by James Molony, Investment Writer at Schroders.
The recent flare up of risk in Argentina, high and rising inflation, currency weakness, concern over the national finances and monetary policy, bears all the hallmarks of a classic emerging market crisis. Given the improvement in fundamentals which has taken place over recent years, do opportunities remain in emerging market bonds?
Other emerging economies, notably Turkey and to some extent Indonesia, are experiencing similar issues. These developments go against, and perhaps even call into question, what has been a long-term trend of improving fundamentals in emerging economies.
While the Argentinian peso is 20% weaker versus the US dollar in May, the Turkish lira has plummeted, reaching record lows against the dollar. Recent months have seen President Erdogan commenting on monetary policy somewhat unhelpfully, for instance claiming the central bank should lower interest rates in order to bring down inflation. This has contributed to the decline in the lira.
Indonesia too, in the past regarded as externally vulnerable, has seen a slide in its currency though its current account has improved markedly over recent years and it is expected to raise rates. Its current annualised growth rate of 5%, well above global averages, has disappointed some.
These specific situations are raising concerns and questions, but over the last few years, emerging markets (EM) have, through self-help measures and reforms, increased their resilience to external shocks. Most EMs have removed currency controls, “orthodox” monetary policy and central bank independence is more commonplace, financial balances have improved and currency reserves been built up. The image of EMs as routinely debilitated by inflation and currency crises seemed to have been consigned to the past.
Back to square one?
Argentina’s 2001 debt default remains one of the most notorious incidents in recent financial memory, but the country had more recently appeared to turn a corner.
The election of President Mauricio Macri in 2015, on a campaign promising market and business-oriented reforms, was seen as a potential sea change. It ended decades of ‘Peronist’ governments, named after former three-times President Juan Peron, widely seen to have badly mismanaged the economy and caused elevated inflation.
Among Macri’s successes was an agreement to repay holdout creditors from the 2001 default, which enabled Argentina to issue bonds again. Its first subsequent bond issue, in April 2016, was the largest EM sovereign issue to date at that time, raising $16 billion. Among ensuing issues came a 100-year bond; a strong vindication of Argentina’s improvement.
Macri eliminated foreign exchange controls and import and export restrictions and cut the corporate tax rate to 30%. As well as this though, subsidies on public utilities and services were removed, resulting in higher prices, likely contributing to a decline in the president’s approval rating.
In December, the central bank softened its inflation reduction target from 12% to 15%. This prompted a selloff in the peso with the central bank seeming to have acted under the influence of the government.
With rising US Treasury yields prompting a US dollar rally, the old nemesis of EM, burgeoning concerns spilled over with the peso weakening 20% versus the dollar in May.
Turbulence interrupting a smooth flight
The last such meaningful occurrence of EM volatility was during the 2013 “taper tantrum” when the Federal Reserve announced tapering of asset purchases. This bout of volatility saw the “fragile five” moniker coined with reference to a group of EM economies, including Indonesia and Turkey, with financial deficits and vulnerable currencies. Emerging economies have made progress since then and are still on a positive trajectory.
EMs have built stronger buffers to shocks during the recent economic upswing, accumulating foreign exchange reserves and improving current account balances (the balance of imports and exports). Indonesia’s, though still negative, has roughly halved since 2013. Brazil, having seen its current account reach a low at the end of 2014, is almost back to breakeven.
There has also been a concerted and more orthodox response to the current woes. The central bank of Argentina has raised rates quickly while the government has secured support from the International Monetary Fund (IMF).
Indonesia’s central bank is also expected to raise rates to support the currency. Most significantly, following a period of President Erdogan’s interventions in monetary policy, the Turkish central bank managed to halt the lira’s freefall by announcing tightening and promising to simplify its system of interest rates.
Any references to securities, sectors, regions and/or countries are for illustrative purposes only and not a recommendation to buy and/or sell.
The fund manager views
Michael Scott, European Fixed Income Fund Manager:
“The current flare up of volatility is confined to specific situations driven by specific risks at an individual country level. So we don’t see a systemic problem developing.”
“The positive fundamentals and dynamics which have drawn us toward both corporate and sovereign emerging market bonds, particularly in Latin American countries, in recent years remain largely in place.”
“Additionally, these countries are idiosyncratic and will be at different stages of the economic cycle, which makes them very helpful from a portfolio construction perspective. They are moving away from the old image of resource-extraction and low-cost manufacturing and exporting, with services and consumption becoming more significant components of these economies; another encouraging trend.”
James Barrineau, Co-Head of Emerging Market Debt Relative:
“A stronger dollar is never good for EM, but the policy responses in Argentina, Turkey and Indonesia have been prompt. They have not wasted significant reserves defending the currency, and as we saw in 2014-2016, when the smoke clears a more competitive currency can pave the way for better economic growth.”
This article has first been published on schroders.com.