‘Emerging markets’ label obsolete as advanced economies become politically risky
Over the past year or so, the pendulum of political risk has swung even further in the direction of advanced economies
Nearly a decade ago, The Economist magazine questioned the appropriateness of the term “emerging markets”.
The label had become somewhat anachronistic during the 2008 global financial crisis when it was developed countries that bore the brunt – and, more importantly, were the source – of the severe banking and macroeconomic woes that wreaked havoc on the world economy.
As China’s aggressive monetary and fiscal stimulus hauled the global economy out of recession, and as the leading emerging markets proved remarkably resilient to the financial mayhem in the United States and Europe, many fund managers and investors began to rethink their asset allocation process, and their perceptions of sovereign risk more generally.
Jerome Booth, a prominent investor and one of the most authoritative commentators on emerging markets, went so far as to say that many developing economies had become “safe havens” because of their much lighter debt burdens, significant economic clout and, in many cases, stronger creditworthiness.
Booth noted that the main difference between developing nations and their advanced counterparts was that in emerging markets, the risks were already priced in. In advanced economies, on the other hand, investors never bothered to price in the risks because they perceived developed nations as more or less risk-free.
These risks, moreover, were as much – if not more – political as they were economic.
In other words, investors had been underpricing (or simply ignoring) political risks in advanced economies, particularly in Europe.
Fast-forward eight years, and based on the distinction between developed and developing economies favoured by Booth, the term “emerging markets” has almost certainly been rendered obsolete.
Over the past year or so, the pendulum of political risk has swung even further in the direction of advanced economies. Just in the past week, cracks in the 60-year-old transatlantic alliance have widened significantly following US President Donald Trump’s decision to pull America out of the Paris accord on climate change. In Britain, meanwhile, the pound is once again under strain as opinion polls show a much tighter race between the country’s two main parties ahead of a crucial parliamentary election on Thursday. And in Italy, the next big test of populist sentiment in Europe, there is now talk of an early election in the autumn.
Make no mistake, investors and traders are far more concerned about political developments in the US and Europe than in Brazil and Turkey.
Just as importantly, the emerging-market asset class as a whole has weathered the effects of last year’s political shocks in Britain and the US with relative ease – admittedly partly because broader sentiment has held up remarkably well. At a time when there is speculation that Trump could even be impeached, emerging markets continue to enjoy a surge in capital inflows. According to JPMorgan, investors poured a further US$2.6 billion into emerging-market bond and equity funds in the week to May 31, bringing this year’s cumulative inflows to more than US$75 billion, compared with US$44 billion for the whole of 2016.
Investors are also treating some of the sovereign and corporate bonds of emerging markets as a safer proposition than the debt of developed economies. The five-year credit default swap spreads – a type of insurance against the risk of default by a particular country or company – of China, Indonesia and Hungary are lower than those of Italy and Portugal.
More tellingly, spreads on high-yield (or non-investment-grade) emerging-market corporate bonds, as measured by the high-yield component of JPMorgan’s benchmark emerging-market corporate bond index , are tighter than their US equivalents, mainly because of the dramatic compression in the spreads on Asian and emerging European high-yield debt.
Yet just because the term “emerging markets” is no longer appropriate does not mean that emerging markets should be treated as safe havens.
While the credit quality of many emerging markets is stronger than that of many developed economies, the argument that developing nations can somehow decouple from their advanced peers does not stand up to scrutiny. The sharp sell-off in emerging markets during the summer of 2013 following the Federal Reserve’s unexpected decision to start winding down its programme of quantitative easing is a reminder of how sensitive the asset class is to financial conditions in developed markets.
Just as importantly, when China sneezes, the world catches a cold. As the International Monetary Fund recently noted, financial spillovers from the world’s second-largest economy by market exchange rates to the rest of the world “are on the rise”.
Risks lurk just as much in major developing markets as they do in developed ones.
Nicholas Spiro is a partner at Lauressa Advisory