The Next Decade’s Natural Realignment Remedies
With major indices still down through October, emerging markets are in their longest funk since the “taper tantrum” five years ago, but the US Federal Reserve and developed world liquidity movements are no longer the main culprits as investors spot weaknesses beyond the current account deficits highlighted then in the so-called Fragile Five including India and Indonesia. This year general global drivers and specific economic, bond and stock market, and regional risks provoked discomfort, aggravated by crises in Argentina and Turkey. These trends will linger into 2019 pending further analytical rigor so that near-term allocation is again a function of detailed country and instrument evaluation. Through end-decade banking system health after an extended credit binge, and productivity prods to faltering growth will be paramount questions, as portfolio managers also prepare for broader landscape shifts. They will encounter index consolidation and redesign, and emerging markets themselves finally seizing control of benchmarking, capital flow direction and global monetary and trade leadership.
The monetary spillover from the US, Europe and Japan, was never decisively quantified, but tens of billions of dollars presumably went annually into higher return core and frontier stock and local and external sovereign and corporate bond markets. The infusion aided currencies, which reversed this year against the dollar with the Fed’s scheduled rate hikes. Commodities outside oil have not provided support, as agriculture and metals prices are flat or declining. Credit ratings were rising last year but since plateaued, with upgrades and downgrades virtually even. Volatility spiked the past few months as managers are under pressure to rotate into equities from bonds after the latter’s decades-long rally. Politics and geopolitics have dampened enthusiasm with new uncertainties about sound government practice and trade and investment relationships. Populism is prominent, with candidates reeling from the old “Washington consensus” of liberalization and privatization. War may still be a danger in Iran and the Koreas but is defined as well by commercial and financial conflict between the developed world and China in particular.
The International Monetary Fund recently again softened its 2019 GDP growth forecast, with the emerging market average at 5%, and only Asia exceeding that number. Domestic demand is sluggish alongside the traditional export-led model, and private investment has been chronically weak. With currency depreciation and higher energy prices, predicted inflation is the same 5% for no growth in real terms. Over the quantitative easing decade, central banks kept policies loose or flat, but their bias is now toward tightening to defend exchange rates and encourage bank deleveraging after prolonged double-digit credit expansion. Fiscal stimulus cannot readily absorb the slack with accumulated deficits to fund budgets and infrastructure. While the balance of payments has returned to current account surplus, often through import compression, the capital account can show not only portfolio outflows but unchanged foreign direct investment, according to the latest UN agency tally. Asian and Gulf foreign exchange reserves stabilized, but the Institute for International Finance regularly warns of thin short-term debt servicing cushions in a cross-section of countries.
Through 2020, external corporate debt, with hundreds of billions of dollars in annual issuance to outpace the sovereign version, faces large maturity humps. The past six months’ drought has ended but rollovers will be more difficult, especially if quasi-sovereigns at half the estimated universe are not backed by governments if facing default. Non-Western official and commercial debt holders may not follow established restructuring rules, as evidenced by the clash between the US and China over proposed Pakistan relief. Foreign investors own an outsize portion of local bonds at almost one-third the total; public equities have embedded distortions with MSCI’s heavy Asian and tech weightings, and private equity has no standard index. In the next investing phase these benchmarks will combine, as JP Morgan has already signaled in bonds. Emerging markets themselves, after launching ratings services such as in China and Russia, will develop competing performance measures. They will better reflect so called “South-South” practice and fund flows, as combined market size converges with the 50% share of the world economy. These new gauges will routinely feature in future analysis, as supporting financial market breakthroughs like the BRICs bank, Yuan swap network, and new trade zones in Asia and elsewhere reinforce policy and performance self- determination despite the bumpy journey to a successor era.