Emerging Market Investors’ Forlorn Faith Healing
All major emerging market asset classes — debt, equity and currencies — led developed world counterparts through the third quarter, with European and Japanese stocks particular losers. The outperformers were the MSCI core share and GBI local currency bond indices in dollar terms, with respective 17 percent and 15 percent gains. External sovereign EMBI fixed-income also was up 15 percent, followed close behind by the CEMBI corporate at 12 percent. The currency gauge rose 7.5 percent on universal recovery after 2015’s double-digit decline. Net foreign retail and institutional investor inflows through ETFs and dedicated mutual funds soared to USD 48.9 billion for bonds and USD 11.9 billion for stocks through the third quarter, according to data tracker EPFR. The former fled the USD 10 trillion zero and negative yield universe of advanced economy benchmark instruments, and the latter benefited from long-predicted global asset class rotation.
Beyond the relative return allocation rationale, portfolio managers cited modest GDP growth improvement to a 4 percent average on better domestic demand and commodity prices, with recession bottoming in BRIC members Brazil and Russia, India dominating the pack at 7 percent, and China’s 6.5 percent target on track. Political and geopolitical fears seemed to recede as Turkey’s attempted military coup was quashed, Brazil’s President was formally impeached after the Rio Olympics, and Middle East and African countries negotiated IMF rescues amid conflict and election disturbance and credit rating downgrades. Asia and Latin America, with currency and commodity relief, were also in position to shift monetary course to easing, especially as credit expansion outside China moderated to single digits. These arguments are valid but thin in justifying more than tactical exposure, regardless of year end central bank moves in the US, Europe and Japan. Developing market sentiment is brighter in comparative context, but durable commitment awaits deeper policy and practical transformations to reinvigorate a sweeping case that can update the golden era of previous decades.
Economic healing is tentative with the manufacturing output PMI barely above 50, and exports flat with world trade growth just 1 percent, according to the latest WTO estimate. In half of emerging markets, real interest rates are negative, deterring savings mobilization. Global oil price stability hinges on OPEC’s recent production freeze agreement, as the cartel remains split diplomatically between Saudi Arabia and Iran, and non-OPEC countries are free to ramp up supply. Private sector debt to companies and households, mainly through domestic commercial banks, is now twice the government load at 120 percent of GDP. It will remain a drag, potentially inviting crisis as bad loans also spike, the BIS and big investment houses continue to point out. IMF programs initially boosted confidence, but have since been delayed or unraveled in Ukraine and Mozambique, while Mongolia and Zambia have hesitated with negotiations.
Corporate high-yield bond defaults are already at 4 percent of the total, and although Brazil’s Petrobras with the largest amount outstanding won a reprieve with new state help, the imminent $7 billion restructuring of Venezuela’s PDVSA raises caution flags, especially as CEMBI spreads near a record low. The annual issuance forecast has been hiked from $200 billion to $300 billion with the wide open window, portending a glut. Sovereign bonds are likewise a crowded position with the EMBI spread over Treasuries in the 325 basis point range, and new issuance pouring in from Argentina and the Gulf. Local market yields have dropped to 6 percent from 7 percent-plus previously. Mexican peso and South African rand-denominated instruments have swung wildly as proxies for risk appetite, and Indian rupee ones are suddenly in the top three most popular despite foreign investment quotas, according to trade association EMTA’s quarterly survey. On equities, the valuation discount with developed world counterparts has narrowed but earnings growth is often absent to scarcely positive, as price-earnings ratios in Asian markets in particular drift to frothy 20 times levels.
On the mainstream EMBI, Venezuela was the top gainer at 55 percent as investors bet possible future presidential recall will overturn socialist direction, even as its stock market was removed long ago from the MSCI counterpart due to capital controls. On that gauge in Asia, China’s “A” shares were a notable exception to the regional upswing with a 10 percent loss through the third quarter. The renimbi entered the IMF’s Special Drawing Right with a 10 percent, weight but the Fund in a report otherwise criticized the pace of banking system and state enterprise cleanup. Despite the target headline growth, the private sector Beige Book reading of thousands of smaller firms showed a retail sales and services slump. Mortgage lending took half of new credit as authorities abandoned former curbs to stoke a short-term home price rise for consumer support. India reversed second quarter negative results in part with passage of national tax reform, but foreign investors will also face capital gains charges with the end of Mauritius domicile exemptions. Indonesia was ahead 25 percent with anti-corruption and pro-business Finance Minister Sri Mulyani reprising her tenure, but mining companies like Newmont exited, citing chronic regulatory burdens.
Latin America was the top MSCI region, and Brazil the core roster overall leader (+ 60 percent) on across the board financial asset bounce from 2015’s route, with economic downturn, interest rate upturn, and political upheaval cycles in concluding stages. However company defaults continued to cascade as new central bank officials tried to reassure about state and private lender health. Peru (+50 percent) was in second place, as former investment banker Pedro Pablo Kucysknsi became President on solid growth and inflation data, along with wider fiscal and current account deficits. However contrary to expectation, he signaled a hard line in a US bondholder dispute held over from previous administrations which was referred to arbitration under the bilateral free trade agreement. Colombia (+30 percent) rallied on the breakthrough guerilla peace accord which was rejected after quarter-close in a referendum, while Mexico was the outlier, off 2 percent with a ratings outlook cut and prospective Trump Presidency commercial and migrant confrontation.
In Europe Russia (+30 percent) was the runaway winner with bargain single-digit P/E values and fading sanctions constraints despite cyber-attack allegations surrounding US elections, which also encouraged fresh corporate and sovereign debt placements. Hungary (+20 percent) recovered investment grade rating status and the government has taken control of the Budapest stock exchange with the intent to facilitate privatizations and small firm listings, although progress has been slow. The Czech Republic and Poland were both down 5 percent through end-September, with possible removal of the post-2008 currency peg in the former, and bank foreign exchange mortgage conversion and private pension confiscation threats in the latter.
Despite the past quarter’s pervasive rally, momentum could again stall toward year end across developing market asset categories on recognition that short-term relative appeal still leaves unresolved economic, political, financial sector and institutional-regulatory issues from the post-2000s boom decade. The 2013 Federal Reserve “taper tantrum” was not as much a reflection of abrupt rate hike concern as a window into overlooked vulnerabilities not just for the “fragile five” countries, and the next phase of anger management will require more profound work for affable disposition to prevail.
