The Seamless Rally’s Frayed Fabric
Emerging bond and stock market performance in 2017 exceeded the most optimistic early year scenarios, largely focused on feared global monetary and trade squeezes that proved overwrought and quickly faded to pave the way for uniform rallies. Benchmark indices were up double-digits, led by the MSCI’s 35%, with almost all country constituents in core and frontier and local and external measures along for the ride in a pattern last seen a decade ago right before the global financial crisis. Then a Shanghai Stock Exchange “shock” was originally felt in New York and other centers before the mortgage meltdown.
Combined investment fund flows last year at $200 billion mirrored the previous peak, with ETFs that have since mushroomed accounting for respective 10% and 25% portions of debt and equity allocation. Better than expected corporate earnings and average GDP growth, again approaching the 5% level of boom periods with higher exports and domestic demand, bolstered enthusiasm as a mix of positive underlying story and low-return advanced economy aversion. However the embrace did not distinguish between asset classes and leaders and laggards within them for a longer term winning strategy, and overlooked banking system and geopolitical icebergs lurking beneath the surface. Financial stability may again be a prominent theme after years of post-crisis relief, as private sector leverage rings alarms and the public sector running steeper fiscal deficits has limited rescue space.
In stock markets by region Asia outstripped Latin America and Europe in the core universe, with MSCI’s addition of Chinese “A” shares and buoyant company profits in the global tech cycle were key drivers. These factors neutralized continued worry over China’s banking stress, corporate debt overhang, and capital outflows which were prominent topics at the Central Economic Work Conference going into 2018. Authorities have already announced crackdowns on shadow “entrusted loans,” state enterprise leverage, and bank card holder dollar deposit withdrawals, and signaled further moves with financial stability a Party priority. In contrast with 2008, economic and credit spillovers from potential crisis would now slam emerging market bonds as well, where foreign investor corporate and sovereign exposure ranks near the top globally in volume trading surveys by the industry association EMTA. Asian neighbors Korea, Malaysia and Thailand are grappling with high household as well as business debt levels, regularly drawing warnings from the IMF and the BIS, which will be tested this year as allocation turns more selective, according to the latest Bloomberg fund manager polls. Korea’s central bank stood out last year by hiking interest rates and imposing credit card “macro-prudential” curbs to shrink OECD-leading 150 percent of GDP personal leverage.
In Europe, Russia lagged with a barely positive MSCI result despite low valuations, as it may face more Western sanctions for election interference, with the US Treasury Department considering a government bond buying ban. It took over systemically-important private banks and had to close hundreds of others for prudential violations. Turkey’s 35% rise was at the opposite extreme, but was due to post-coup attempt official loan stimulus overheating the economy and stretching the banking system, which has to rollover heavy foreign exchange obligations. Foreign investors as the largest owners trimmed local bond positions in Hungary and Poland, as they recoil at populist administrations courting EU condemnation and aid suspension, and fear that domestic institutional investors lack backup capacity after private pension fund shutdowns.
Latin America has a nonstop 2018 election calendar with presidential contests in Brazil, Colombia and Mexico, with the main parties and their standard bearers offering scant commodity diversification and productivity raising platforms under scandals and criminal investigations. Brazilian banks, including the development BNDES arm, continue to deal with large corporate borrower restructurings, such as with telecom firm Oi. Argentina’s economic policy turnaround and world capital market re-entry under President Macri, which resulted in record borrowing and a near 75% MSCI Frontier Index bounce in 2017, is offset by Venezuela’s implosion under a harsher socialist regime bringing hyperinflation, debt default and a singular humanitarian catastrophe.
Frontier market stumbles in the Middle East and Africa left the composite gauge 10% below MSCI’s main roster, as Gulf and Southern African components suffered respectively from the Qatar boycott and South Africa-Zimbabwe political transition jitters, which have also hurt bank liquidity and profitability. A big warning to the overall asset class is the Institute for International Finance’s lending conditions survey stuck around the neutral 50 mark, which fund managers have yet to flag it for future momentum drag. They will better pick their spots in the coming months, and although stock returns likely will continue long-term catch up with bonds, variation will widen by geography and development stage through the financial sector health filter.