External risk factors are nothing new for EM investors. But what is different from the past is that the key driver of risk is the US, where the policy environment has become less predictable.
At a basic level, accounting for the external factors influencing emerging market (EM) economies used to be a relatively straightforward task. If you kept an eye on Fed policy, U.S. dollar trends and the International Monetary Fund (IMF), you could go quite a long way in understanding the most important external variables for these economies. That is no longer the case.
For a long time, EM investors have been only too aware that higher U.S. interest rates and a stronger U.S. dollar are typically bad news for EM debt investors because they imply tightening global liquidity and increased external debt servicing burdens in local currency terms.
Of the external factors impacting EM economies, geopolitics has been relatively calm for the last couple of decades and less important. That is changing and it requires a different skill set from investors.
The preeminence of the U.S. as a global hegemon is under threat from the rise of China. The U.S., in turn, is seeing its international role in the world in narrower terms. President Donald Trump is using more sanctions than his predecessors and opting for bilateralism over multilateralism.
This poses conceptual and practical challenges for investors. Conceptually, much of the way that investors think about global markets is premised on the preeminence of the U.S. At the most basic level, if that changes over time, we think that investors’ assumptions about the role of the U.S. also will have to change.
This will have an impact on the way we view the institutions that control global governance, too.
The IMF and World Bank still play a pivotal role in emerging markets and it is difficult to see that changing any time soon, in our view.
But the Trump presidency has undermined the World Trade Organization, which was essentially the poster child for U.S. trade policy for decades. We feel that the IMF also could find itself caught up in the crossfire between Trump and China.
Sanctions are familiar to EM investors, but what we have seen in the past two years is not.
In the past, sanctions generally came courtesy of the United Nations. They were reasonably predictable and focused in nature.
In contrast, many of the U.S. economic sanctions over the last two years have been hard to predict and have apparently unintended consequences.
The sanctions imposed on Russian aluminium maker Rusal and its owner Oleg Deripaska in April 2018 had a significant impact well beyond the company and individual. The entire global aluminium market, a vast swath of Rusal’s suppliers in and outside Russia were severely affected and almost no one saw them coming.
We believe that this pattern of sanctions will continue in 2019. Predicting them will be difficult, as much seems to hinge on Mr Trump. Nonetheless, we think that investors will need to try to understand their impact—requiring a more detailed analysis of transmission mechanisms of sanctions, through mechanisms such as supply chains.
Sanctions are not the only new external factor. The U.S.-China trade war is having a fairly unequivocal and clear impact on the open economies of most EMs that are premised on open global trade.
Properly understanding the implications of the trade war will require much more analysis than just looking at the brinkmanship alone. Anything beyond the first-order implications will take until well into 2019 to fully understand regardless of whether the trade war ratchets up or down in the short term.
The new era of geopolitics will also force investors to revisit past assumptions. The close correlation of the Russian ruble and oil has been disrupted over the past year by sanctions. Rusal sanctions in April 2018 sent the ruble down as oil held steady and then rallied as the oil price fell at the end of the year because anticipated new sanctions failed to materialize.
Yet more external factors could become relevant next year. In our view, Mr Trump’s threats to cut aid to several countries could yet turn into more than words. The impact for some countries would be slim. For example, it would amount to around 0.4% of gross domestic product (GDP) for El Salvador and Honduras and 0.2% of Guatemala’s GDP.
While such cuts are manageable, those proposed for Venezuela are not. Likewise, if Trump were to push back on IMF support for countries that have borrowed significant sums from China, as U.S. Secretary of State Mike Pompeo has done with Pakistan, that would not bode well for a broad swath of countries in Sub-Saharan Africa.
External risk factors are nothing new for EM investors. But what is different from the past is that the key driver of risk is the U.S., where the policy environment has become less predictable.
The impact from changing U.S. policies could be far-reaching, weakening the influence of multilateral institutions and the countries that are dependent on their support. The world is changing; we think that EM investors also need to change.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase). Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.