Emerging market assets are running on empty


Stocks and bonds are rallying but growth forecasts are being cut all over the world

by Jonathan Wheatley

There is bad news and good news for emerging market investors this year. The bad is that EM growth is tanking; the good is that there is money to be made while it tanks. The question is, for how long can something that is clearly bad for emerging economies be of benefit to those who invest in them?

Prices of EM local currency bonds, for example, have risen almost 8 per cent this year, according to the benchmark JPMorgan index. Most of that gain has come over the past six weeks, as trade tensions between the US and China have eased and expectations have risen for interest-rate cuts by the US Federal Reserve and a host of EM central banks.

Yet this has happened at the same time as a string of downward revisions in forecasts for global and EM growth this year. From a consensus of about 5 per cent at the start of 2019, many economists have cut their outlook for EM growth this year to as little as 3.5 per cent.

As with the “Greenspan put” and now the “Communist party put”, investors appear confident that policymakers will respond to a worsening economic environment by cutting interest rates and otherwise increasing the flow of cheap money — and thus fuelling a global hunt for yield once again.

But as a decade of experience since the global financial crisis has shown, cheap money tends to stoke asset prices while not doing much for productive investment.

“It might be that we are in an environment where financial conditions are very favourable but there is no real productive outlet for that money,” says Michel Nies, an EM economist at Citi. “So dovish conditions do not have the impact on growth that they had in the past, or the impact comes in channels that have downside, like credit-fuelled consumption or fiscal profligacy.”

According to the website Central Bank News, 30 central banks have cut interest rates so far this year, of which just three were in developed economies (if you count Iceland as developed, despite its imminent inclusion in the FTSE Russell and MSCI equity indices for “frontier” markets). Plenty more are expected to follow.

“It feels like EM central banks are being asked to please form an orderly queue,” says Paul Greer, portfolio manager at Fidelity International.

Many policymakers, such as those in Colombia and Brazil, began cutting rates early last year, long before the Fed flipped from a hawkish to a dovish stance. Inflation has been falling in much of the emerging world for a good six to nine months, with month-on-month deflation cropping up this year in Thailand, Malaysia, South Korea, Peru and others.

This marks a reversal from previous conditions when many policymakers were aggressively raising rates to keep inflation expectations in check. Mexico, for example, raised its policy rate from 3 per cent in 2016 to 8.25 per cent last year. Since then, annual inflation has fallen from 5 per cent to less than 4 per cent today and is expected to keep dropping.

This and other examples make a powerful case for being long local currency bonds, says Mr Greer. But he is less optimistic about EM currencies, even though he still regards them as cheap. They have had a good run recently but “we are mindful that this is not a classic EM currency rally”, he says. “Currencies are very sensitive to global growth and global trade and those are both going south.”

Which brings us back to the opening question. Despite the recent rally, local currency assets — currencies, stocks and local currency bonds — are all below their peaks of early 2018, before the unexpected strength of the US dollar triggered a broad sell-off across EMs. This year, their rally went into reverse in the second quarter, though they are once again at or close to year-to-date highs.

“The fizz of EM assets in the second half of last year has begun to fade but they have been supported by the shift in expectations for the Fed,” says William Jackson, chief EM economist at Capital Economics. “But as the global economy continues to weaken, it could cause risk appetite to worsen and make the second half tougher for EM assets.”

This raises the bigger question of what, if anything, will deliver a rebound in EM growth. It is possible that cheaper credit will boost confidence, consumer spending and even investment. This is clearly what policymakers are hoping for.

Mr Jackson is not optimistic. “We are seeing some pick-up in those countries that have fared poorly but it’s likely to be pretty slow,” he said. “We’re looking at growth of 1 to 1.5 per cent in places like Mexico, Russia and Brazil, which would have been extremely disappointing five years ago. But there isn’t anything you can clearly see that would drive a more significant rebound.”


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