Emerging Markets: A risk to your psyche, or your money?
Investors usually make one of two mistakes; they either overreact or underreact to news.
I used to love London for its cool weather. Alas, those days are gone. At more than 28°C outside, my top-floor flat without air-con is now something of a greenhouse. The temperature in my home office is close to 40°C. As the heat rises well beyond my comfort level, I am trying to keep a cool head, when reflecting on the current state of emerging markets (EM) and investor psychology. To me, it feels that fears around EM debt represent more risks to investors’ psyche than to their money.
Investors usually make one of two mistakes; they either overreact or underreact to news. Often the reaction will be driven by a lack of comfort with a certain investment thesis, alongside a home bias. While EM has evolved as an asset class, for some investors select countries can still be an exercise in geography, rather than economics. It’s not surprising that in times of uncertainty, investors become more apprehensive and prone to suspicion when investing in EM. Newspapers, moreover, are becoming more confident in reporting sensational EM headlines. Is investing in EM today a risk to investors’ psyche or to their money?
So far this year, all EM debt sub-asset classes have underperformed not only other fixed income asset classes but also EM equity, defying traditional assumptions regarding risk assets’ volatility. Spreads on EM hard currency sovereign debt have widened by 40% year-to-date from 260 basis points to 360 basis points, reaching spread spikes last seen during the post-Trump election sell-off or mid-201S commodity crisis. Looking at performance differentiation, EM countries were split in two camps: those countries dominating FT headlines that performed really badly (Argentina and Turkey, to name but two) and those that just performed badly. We didn’t see much performance differentiation in the second camp, with countries such as Lebanon and Nigeria delivering similar returns despite a tenfold difference in debt-to GOP ratios, and differing sensitivity to oil, growth or current account dynamics.
While the fundamental trajectory of EM has not changed meaningfully over the last three months, tail risks in investors’ minds have become fatter. Looking at hard numbers, EM fundamentals remain robust, especially from an external debt perspective. Over the last 20 years we have seen almost a 30% reduction in external debt-to-GOP ratios, from 37% down to 26%. EM countries, even excluding China, are running net current account surpluses; in other words, they are seeing US dollar inflows.
What are investors’ fears? While the list is long, the top three in my view arc a risk of a credit event, the impact of tighter liquidity, and policy fears related to questionable EM leadership.
- The risk of a credit event might be the least unpredictable among the three. This is because EM investors have witnessed a long history of credit crises and overall ratios do not point to excessive leverage or vulnerability. Anecdotally, from my trips to the twelve most vulnerable countries over the last few months, I believe that a likelihood of an external debt restructuring with broader market contagion is low. While Lebanon, alongside Zambia and possibly Ukraine, could be in the most vulnerable camp, this is unlikely to come as a surprise to investors.
- Liquidity risk is probably the most difficult to assess. It is multi-faceted, encompassing the risk of a higher cost of US dollar liquidity, the risk of a lower provision of liquidity by market-makers and refinancing risk. The market does not have institutional memory of quantitative tightening combined with rate hikes in the US. Hence the cost of tighter US dollar liquidity is difficult to price. At the same time, banks that had already been reducing the provision of liquidity to their clients across risk assets are facing even further balance sheet constraints, turning them into broker-like operations. Yet, so far, EM countries have coped well with refinancing risk – Argentina has successfully secured an IMF deal to address its refinancing needs over the next two years. Even in Turkey – one of the countries with the highest stock sort-term debt – rollover ratios have been around 100% year-to-date.
- Then there’s the EM leadership dilemma. It’s difficult to get excited about the market-oriented policies from the likes of Vladimir Putin in Russia or Andes Manuel Lopez Obrador, who recently won elections in Mexico. Re-elected Turkish President Erdogan did not cover himself in glory when he gave a lecture in London to investors on the negative impacts of high interest rates on the economy. Yet performance history shows a different relationship between economic results and leadership rhetoric than the market might have anticipated. Often it comes down to the path of least resistance and economic reality. Argentina has been the worst EM bond performer this year, despite its pro-market darling President Macri, while Russia has been among the best, despite its controversial president and the sanctions imposed by the West.As I finish typing my thoughts in my overheated apartment, I am not looking forward to the weather in my travel destination tomorrow – Tokyo. My brother, who lives there, described it as a Japanese sauna experience with temperatures being well above 30C. Hopefully the markets won’t follow the overheating pattern and investors’ cool heads will prevail.
Polina Kurdyavko, Bluebay Asset Management
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The opinions expressed are those of Bluebay Asset Management and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research of advice.