Performance Indices’ Indelible Injury
Last year’s thrashing in all emerging market investment classes, with debt, equity and currencies in simultaneous decline for the first time in a decade, cast equal blame on internal and external forces and provoked a long overdue rethink of allocation rationale into the next decade. For years bonds in particular were spared lasting correction with the global rally from industrial country central bank monetary easing, or the whole category reacted in lockstep to outside liquidity, trade, political and geopolitical steps affecting portfolio values. The 2018 Argentina and Turkey crises as a wake-up call were in part a replay of the Federal Reserve Taper Tantrum hitting the Fragile Five countries in 2013, as retail foreign investors especially sold indiscriminately without detailed knowledge of economic, financial system and technical underpinnings. Contagion may yet spread beyond sentiment and be justified by fundamentals such as bank weakness as the business and credit cycles turn, but for now index performance will continue to be subdued without the specter of uncontrolled crashes. A worst case China meltdown scenario as a possible trigger would damage world markets broadly, unlike the version a decade ago when the rest of Asia and commodity exporters were mainly in the firing line.
The dollar’s strength against all emerging market currencies was a drag, but may again fade as developing world central banks also raise benchmark rates contributing to slower growth. Government borrowing for possible fiscal stimulus will reinforce tightening pressure, against the backdrop of mixed commodity price and credit ratings trends. Lower hydrocarbon values, with oil falling to $50/ barrel, prompted sovereign and corporate downgrades, which continue to run even with upgrades with the overall average at the investment-grade margin. Populism as a political backlash against globalization, immigration, income inequality and technology change is on the march notably in Central Europe and Latin America after the US and Brexit experience. Geopolitics in turn increasingly centers on trade and aid conflict between Washington and Beijing and their respective allies, with tariff retaliation and pact renegotiation standard tools. Spikes in financial market volatility from computer-driven trading and debt-equity rotation add to the cross-currents looming over asset choices.
The International Monetary Fund downgraded average growth to 4.5% this year on inflation slightly below that level, with foreign trade and direct and portfolio investment due to slacken and stay in the $1 trillion range to major emerging markets, according to the Institute for International Finance. Short-term reserve coverage as a portion of external debt is thin beyond Argentina and Turkey, in places including Chile, South Africa, and Pakistan. Structural reform momentum stalled during the easy money era, with India held up as a rare bold example, but its reputation was badly dented by the central bank head’s resignation over government interference. Relative monetary policy independence to foster price and exchange rate stability, a longstanding fund manager assumption, may now be at risk as authorities also grapple with the fallout of large corporate and household debt loads on bank health. Across the universe and best-known in China, shadow banks and fintech providers are new intermediaries in the system which often escape regulation and have not experienced distress.
Fund trackers put stock and bond inflows at only $20 billion each in 2018, with a meager pickup predicted this year. For the former, China and Korea were favored destinations because of their big weight in the MSCI index, and tech companies are also a big component as the global industry cycle sputters. Valuations are widely discounted to developed markets, but earnings growth is lackluster and fast-moving exchange traded-funds account for one-quarter of participation. In bonds, sovereign and corporate issuance droughts lasted for months last year, and 2019’s totals are projected to further fall to limit refinancing as $2 trillion in combined local and foreign currency maturities come due. Official defaults would already be widespread in Africa without IMF program rescues, and recent Middle East entrants look to JP Morgan index inclusion as the remaining catalyst with reduced placement. While conditions remain sobering, markets and classes will turn selectively positive, as complex layer appreciation returns to replace knee-jerk reaction in determining direction.
