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By Joyce Huang, CFA - May 31, 2018
Emerging markets (EM) are grabbing headlines in this time of heightened global market volatility. The latest turmoil remains limited to only a few developing countries, but media reports are fanning fears of contagion. We believe these fears are unfounded and investors should look beyond the headlines to focus on still-solid EM fundamentals.
The primary drivers of the recent sell-off among EM stocks and bonds are rising U.S. Treasury yields and a stronger U.S. dollar. In addition, geopolitical influences, rising oil prices and moderating developed market (DM) growth play a role.
The dollar’s path is largely a reflection of the policy divergence among global central banks. While the Federal Reserve (the Fed) continues to tighten, other central banks remain cautious and accommodative. This has contributed to the dollar rally.
The dollar’s relative weakness in the last few years has helped drive EM assets higher overall, so some investors are concerned that the dollar’s resurgence will cause the EM rally to stumble. However, unlike previous periods of U.S. dollar strength, we believe most EM countries are positioned to better withstand the effects. In particular, EM growth is stronger; current account balances1 in most countries have improved; and EM inflation generally remains close to or below central bank targets. Muted inflation remains key because in this environment currency weakness is unlikely to trigger central bank action disruptive to EM growth.
Tighter global monetary conditions, rising U.S. interest rates, and U.S. dollar strength are all pressuring the Argentinian peso. The central bank’s initial reaction to the pressure wasn’t great; it burned roughly 12 percent of its currency reserves before hiking its benchmark interest rate to 40 percent. It also announced a more aggressive primary deficit target this year (2.7 percent of Gross Domestic Product (GDP) from 3.2 percent previously). The government requested assistance from the International Monetary Fund (IMF), but this will be a difficult path to negotiate. The new government will have to balance the economic consequences of not receiving IMF assistance against the political risks of implementing IMF-required budget cuts and austerity measures.
We believe investors have grown impatient with the pace of fiscal adjustment in Argentina. The current account deficit has been on a sharp deteriorating trend due to rising imports, and this has amplified Argentina’s need for larger amounts of external financing. Because the central bank relaxed its inflation target in December and lowered policy rates, investors are questioning the central bank’s independence and commitment to the disinflation process. Despite these challenges, we have not seen contagion into other Latin American countries, and we still view broad EM debt fundamentals as strong.
Any country with a high current account deficit, such as Turkey, is at risk of facing the same troubles as Argentina. High current account deficits are viewed as negative during times of rising U.S. rates and a strengthening U.S. dollar due to pressure they create for local currencies and increased borrowing costs for foreign governments.
Turkey and Argentina each have deficits of more than five percent of GDP and double-digit inflation. These figures are notably higher than other EM countries that have been more cautious about current account deficits since the “Taper Tantrum” of 2013. Indonesia, which is also at high risk, recently started hiking interest rates to defend its currency.
We believe the trade dispute between the U.S. and China will have little impact on China’s overall economy, but it has prompted investors to cut their positions in China amid rising growth uncertainties. Nevertheless, we continue to have a positive outlook toward the country, because its economy is showing no signs of an imminent slowdown.
On May 9, Malaysian voters ousted the regime that had ruled the nation for 61 years. The unexpected turnover caused more uncertainty in financial markets and raised investor concerns about the stability and effectiveness of Malaysia’s new government. Key risks include a widening of Malaysia’s fiscal deficit and cutbacks in China’s investments in Malaysia. However, we think it’s important to remember that Malaysia comprises less than three percent of the broad EM equity universe (MSCI EM Index).
EM equities and currencies tend to fall as oil prices decline and rise as oil prices increase. This is particularly true when global demand is driving oil prices. However, when prices sustain a rise of more than 45 percent to 50 percent year over year, higher oil prices can have a negative influence on EM assets. That’s the point at which oil prices become inflationary, triggering faster central bank tightening or a weaker balance of payments. Net oil exporters, such as Russia and Saudi Arabia, will likely be winners, while net oil importers, such as South Africa and India, are most vulnerable to higher oil prices.
Although the pace of developed market expansion appears to be decelerating, data continue to suggest growth remains healthy in most regions of the world. Global GDP growth remains a key fundamental, supporting our still-positive outlook for EM equities. The difference in growth between EM and developing markets still favors EM, and it continues to gain momentum. Furthermore, EM earnings growth forecasts remain robust and equity valuations appear reasonable.
If we are truly entering a period of structurally lower growth, EM equity index returns may be subpar, and volatility may move higher. The dispersion of returns among EM countries is likely to be high, which underscores the importance of being selective and opportunistic. We will rely on research and resources to uncover attractive investment opportunities and avoid potential pitfalls, to meet our clients’ needs in this changing market environment.
We believe active managers are well positioned to exploit inherent inefficiencies in emerging markets.
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Emerging markets (EM) are grabbing headlines in this time of heightened global market volatility. The latest turmoil remains limited to only a few developing countries, but media reports are fanning fears of contagion. We believe these fears are unfounded.
May 31, 2018
1The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the goods and services it exports. The current account includes net income, such as interest and dividends, and transfers, such as foreign aid, although these components make up only a small percentage of the total current account.
International investing involves special risks, such as political instability and currency fluctuations.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.