With rising U.S. interest rates and the U.S.-China trade war intensifying, 2018 was a volatile year for emerging markets (EM). The U.S. dollar’s strength led to broad-based EM currency depreciation, aggravated by currency crises in Turkey and Argentina. In this article we examine the prospects for EM debt in 2019.
Letters between Beijing and Washington
Examining fundamentals, we believe that there are reasons for optimism. A few countries aside, debt is not at levels that would present systematic risks, in our view. Furthermore, we feel that the robust economic growth rates of EM countries provide a tailwind for the asset class. While we think that growth is likely to remain soft at first, the differential over developed markets should increase as the year progresses. Consequently, we believe that capital flows into EM should improve.
Continued economic strength in the US that results in a hawkish Fed would be an adverse scenario for emerging markets.
The U.S. growth cycle is also important. We expect U.S. growth to moderate but avoid a recession; this would prompt the U.S. Federal Reserve (Fed) to conclude its rate-hiking cycle, relieving the pressure on EM currencies. However, continued economic strength in the U.S. that results in a hawkish Fed would be an adverse scenario for emerging markets, as currencies again would be expected to depreciate against the dollar. In our opinion, the result of the U.S. midterm elections, which should reduce the chance of further fiscal stimulus, offers grounds for optimism.
Another potential catalyst is China. In addition to US tariffs taking effect, China’s economy is slowing; gross domestic product (GDP) growth for the third quarter of 2018 was the lowest since 2009. However, Beijing has considerable monetary and fiscal firepower at its disposal (see Chart 1). The Chinese government already has made efforts to improve corporate access to credit, and issuance of municipal bonds to fund infrastructure investments has been rising. Should these measures prove insufficient, we think there will be further monetary easing, more local-government bond issuance and, potentially, a cut in corporate taxes. The positive impact on EM debt markets is likely to be smaller than the massive infrastructure-related stimulus measures of 2009 and 2015-2016, but it could still be considerable, in our opinion.
Source: China Bureau of Statistics, Haver, Aberdeen Standard Investments (as of November 2018)
Against these positives, there certainly are risks. The most obvious danger, in our view, is an intensification of the U.S.-China trade war. The temporary ceasefire agreement reached at the G20 summit in Argentina in November 2018 already looks fragile, and we believe the most likely scenario is that U.S. protectionism will persist, jeopardizing global trade. We feel that China will remain the focus, although global tariffs on cars represent an additional risk.
But given the unpredictability of the U.S. presidential administration, we think that the trade war may end sooner than most expect. Any resolution of the conflict would significantly boost investor sentiment towards emerging markets—especially as an escalation of hostilities is already priced in.
Elections on the horizon
Politics also presents risks, although these are likely to be more country-specific than the consequences from 2018’s elections in Mexico and Brazil. In Argentina, President Mauricio Macri is currently level in opinion polls with Former President Cristina Fernández de Kirchner, a populist. Macri’s hope is that the economy will recover in time for the country’s election on October 2019, but this might be overly optimistic. If Kirchner wins, we believe that her previous statements will make it difficult for the markets to imagine her cooperating with the International Monetary Fund (IMF) on the reforms that the country so urgently needs.
In South Africa, the ruling African National Congress most likely retain its parliamentary majority, but the margin of victory might change the balance of power between President Ramaphosa and his party rivals. The country’s credit rating1 has been on a downward trajectory over the past few years, and decisive policy action is needed to change that. This can only be achieved under an empowered president. Meanwhile, India’s ruling Bharatiya Janata Party has been pressing ahead with much-needed reforms, but further progress depends on it retaining its position in the 2019 general elections. Recent defeats in state elections suggest that this is far from certain.
Ukraine, however, is a special case. Its debt sustainability remains questionable, but the country has been in an IMF program that has helped it to implement important structural reforms and regain market access. However, we think that the nation’s presidential election in March 2019 could imperil this. Former Prime Minister Yulia Tymoshenko currently has a significant lead in the polls on a populist agenda. Given rising geopolitical tensions with Russia, we feel that Ukraine also represents a potential geopolitical flashpoint.
Finally, there’s oil. Despite recent weakness, the oil price is still higher than the assumptions baked into most EM budgets. But a weaker oil price is likely to benefit local-currency debt markets rather than their hard-currency counterparts. That’s because oil importers–including India and many other Asian countries–comprise a higher proportion of local-currency benchmarks than oil exporters, who have a greater share of the hard-currency indices. Therefore, we believe that there are opportunities as well as risks in this market.
Overall, 2019’s risks appear largely country-specific, in our judgment. The potential catalysts for positive performance, however, are broader-based, and the systematic risks2–such as a step-up in the U.S.-China trade war–are already priced in. Consequently we enter 2019 with some confidence, albeit tempered with caution.
1Standard & Poor’s credit ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. Typically, ratings are expressed as letter grades that range, for example, from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from “AA” to “CCC” may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.
2Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.
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.