Emerging markets: it’s the US economy, stupid!
Emerging market bond investors are in the awkward position of having to wish for bad economic news. Not in EM, but in the US, where the roaring economy is driving the Federal Reserve into a fast tightening cycle that has savaged the investment case for EM bonds and pushed several weaker states to the brink of catastrophe. As Lewis McLellan reports, the recent plunge in US equities offers a whiff of hope.
The lean years are arriving for emerging markets. After a decade of loose monetary policy all over the world, which kept investors rich in cash and hungry for yield, the tide has turned. Central banks are tightening the screws, and emerging market countries and companies are feeling the pinch.
“The withdrawal of global liquidity, particularly the Federal Reserve’s tightening and the unwinding of its balance sheet, is a serious headwind for emerging markets fixed income,” says Paul Greer, senior portfolio manager at Fidelity in London.
As ever, there is more at play than monetary policy. The countries suffering worst from the withdrawal of the US Federal Reserve and European Central Bank’s largesse are those with other vulnerabilities — particularly Turkey, Argentina and Russia.
Each has its own, very specific problems. Russia, home to some of the biggest users of international capital markets, was locked out of them almost entirely in April, when the US fired a sudden salvo of sanctions at Russian companies and individuals, including the oligarch Oleg Deripaska and Suleiman Kerimov, as punishment for Russian actions including interfering in US elections and supporting President Assad in Syria.
So far, Washington has not gone as far as to sanction Russian sovereign debt, perhaps partly because of the damage it would cause US investors and the financial turmoil it could provoke. Many believe that the US is unlikely to extend its sanctions of Russian entities at all, and will instead try to walk back towards a more accommodative position.
In bond markets, the result was a long gap, broken in November when Gazprom returned to international markets, raising €1bn of seven year cash at a yield of 2.949%. In March, it had issued a €750m eight year at 2.5%. Thn later that month, the sovereign made a surprise return raising €1bn of seven year bonds.
However, the sovereign and Gazprom’s re-entry does not herald an easing of conditions for other non-sovereign borrowers in Russia. Gazprom has long been regarded as so important to the supply of energy for Europe that it was very unlikely to be sanctioned. Lesser Russian borrowers are preparing for the possibility of being shut out of dollar debt markets for the foreseeable future.
They have proved resilient, however, turning to local markets to meet their most pressing needs. Most are well positioned, with plenty of cash on hand and only limited maturities to manage. The rouble is also standing up well, having fallen 12% since April to Rb67 to the dollar — nothing compared with its 53% drop to Rb71 when the oil price tanked between July 2014 and January 2015.
Argentina’s pain is more acute, and follows much more closely the script for emerging markets when US rates rise. Inflation is its Achilles heel and it took off again in 2018 as the dollar strengthened and president Mauricio Macri cut subsidies on utility prices.
The peso, worth $0.16 as recently as 2013, clung on between $0.07 and $0.05 throughout 2016 and 2017. But in April it fell off a cliff, and is now just $0.027. The central bank was forced to hike interest rates to 40% in April and 60% in August in a desperate bid to arrest the slide. Macri went cap in hand to the IMF in May to request a stand-by agreement, and in August was forced to beg again for early disbursements of the $50bn the IMF had agreed to lend.
Even that failed to prevent the yield on Argentina’s 10 year bonds shooting to over 10% (a cash price in the 70s) in September.
Beset from all sides
Turkey’s woes combine the political and the economic. The lira suffered a 45% depreciation against the dollar from the start of 2018 to mid-August and, though it has regained some of its value, the country’s credibility has not recovered, leaving borrowing costs painfully high.
At the height of Turkey’s woes in August, investors feared the nation’s economy was imploding. The central bank’s failure to deliver a rate hike expected in July, sorely needed to curb spiralling inflation, combined with the US’s imposition of sanctions on Turkish ministers because of the nation’s refusal to release pastor Andrew Brunson, wreaked havoc on Turkey’s currency and debt spreads.
The developments in Turkey and Argentina have sent a shudder of horror through the emerging market investment world, prompting some to speculate that investors were no longer willing to consider EM assets on their own merits, but were writing off the whole asset class because of idiosyncratic problems with particular credits.
EM bonds sold off across central and eastern Europe, Africa and Latin America, even though the problems in Turkey and Argentina were unlikely to have any direct effect on their neighbours. Emerging market contagion looked like it was back.
Part of the effect was attributable to Turkey and Argentina being important constituents of EM indices, so a sell-off in those countries dragged down other credits. The yield on the JP Morgan Emerging Markets Bond Index widened from 5.5% at the start of the year to 6.6% in August.
However, the problem was likely exacerbated because Turkey’s and Argentina’s troubles came to a head in the summer, when new debt issuance was in its traditional lull. Low volumes, combined with an investor base twitchy from currency crises and sanctions on Russia in April, made the moves look more severe.
In the event, Turkey was able to halt its sliding currency and, although it still faces a recession and high inflation, it has already returned to the bond market. Its neighbours in the Middle East and Central Europe have had no difficulty in accessing the market as and when they choose. While yields have risen across the board, the blame for that cannot be laid at Turkey’s door.
While Argentina’s problems are likely more severe, it, too, has enjoyed three months of relative stability in its exchange rate since the beginning of September. Its neighbours in Latin America have their own problems, and are certainly no darlings to EM investors, but once again, Argentina cannot be held responsible.
Fed steps on the brakes
Idiosyncratic issues aside, emerging market bonds have had an incredible run over the past two years or so. The European Central Bank’s programme of quantitative easing and historically low rates in the US meant that investors were longing for yield and more willing than usual to descend the credit spectrum to get it.
As a result, EM borrowers have been able to raise unprecedented amounts of cash, locking in long term debt at interest rates they could never otherwise have achieved.
But the years of plenty are coming to an end. The ECB’s asset purchase programme is expected to wind up at the end of 2018. The US Federal Open Markets Committee is pursuing an aggressively hawkish trajectory, bringing interest rates in the US sharply higher, to deal with the burgeoning growth rate and rapidly falling unemployment rate.
The surge in yields available on European and US debt is allowing investors to return to core markets to hit their targets.
The Fed’s interest rate hikes have also caused the dollar to strengthen, further damaging the appeal of emerging markets for investors, since the strong dollar heightens the risk of EM borrowers being unable to service their hard currency debt.
While Turkey and other emerging markets are striving to get their houses in order, the conditions for them in the global marketplace are worsening. If the US continues its remarkable pace of growth, then the Fed will have no reason to slacken the pace of its rate hikes, in spite of the wishes of the Fed’s most irascible critic, US president Donald Trump.
“The US economy is at risk of overheating if it doesn’t continue to hike rates, and while the rate hikes continue, the picture is bleak for emerging markets borrowers,” says a sovereign strategist based in London.
It is possible the Fed will switch to a gentler pace of rate rises. The US’s pace of growth has been supported by both monetary and fiscal stimulus, in the form of tax cuts. So as the boost from those stimuli wears off, the economy may slow.
“US corporate leverage and consumer debt are very high,” says Greer. “Thirty year mortgage rates are close to 5%. Higher interest rates could slow down economic growth.”
Third quarter corporate earnings have been, at best, mixed. The tech companies that have driven US stock markets’ meteoric 2018 rise have taken knocks. Apple’s share price has fallen 26% since its all-time high at the beginning of October, although this only takes it back to May’s level. Facebook has fallen 40%.
Should the equity markets’ disastrous performance in October and November, which wiped out all the S&P 500’s gains this year, be repeated, the Fed might find itself inclined to reduce the planned number of hikes.
“If there’s a moderate slowdown in the pace of US growth, the rate hikes priced in for next year might unwind and the Fed’s language might turn doveish,” says Greer. “That would improve the outlook for emerging markets.”
Finding the right price levels for bond issues in 2019 will be challenging. While EM valuations look more reasonable to investors than they have for two years, if US growth keeps up its pace, the dollar still looks undervalued and EM will remain a tough sell, despite the extra yield.
Perhaps the best emerging markets can hope for is what Greer calls “an orderly cooling of the US economy”. With that, valuations in emerging markets will start to look attractive. But if the trajectory does not change, the new levels may not be enough, and emerging markets borrowers will be forced to tighten their belts.