The easy money has been made, but expect emerging markets to continue to do well in 2018
The rally in developing economies still has legs, just don’t expect 2018 to deliver the kind of returns we saw this year
As 2017 draws to a close, emerging market assets are showing signs of strain.
Inflows into emerging market bond and equity funds have been much more volatile over the past few months. Last week, equity funds suffered outflows for the third time in the last six weeks while investors in bond exchange traded funds (ETFs) – popular low-cost funds which track an index or specific asset – have been withdrawing money in the last few months, according to data from JP Morgan.
The US dollar, moreover, whose sharp fall this year has been one of the key drivers of the dramatic rally in emerging markets, is rising again, with the dollar index (a gauge of the performance of the greenback against a basket of its peers) up 2.7 per cent since early September. Last week, the greenback had its best week this year.
The dollar’s renewed appreciation may have further to run.
On Wednesday, the Federal Reserve is widely expected to raise interest rates for the third time this year and may be forced to accelerate the pace of monetary tightening if the tax package currently making its way through Congress ends up stoking inflationary pressures. This would drive the dollar up further, putting emerging market currencies and local bonds under strain.
Then there is the other major threat to sentiment towards developing economies: China. Beijing’s growing determination to curb debt-financed growth has already triggered a sharp sell-off in China’s government bond market and is fuelling concerns that the economy will slow, thus crimping global demand for commodities. The Bloomberg Commodities Index, which shot up 11 per cent between late June and early November due to the improved outlook for commodities, has fallen more than 4 per cent over the past month partly because of renewed concerns about China.
Yet the biggest risk in emerging markets stems from their growing appeal among international investors. According to JPMorgan, inflows into emerging market bond and equity funds have reached nearly US$180 billion this year, putting them on track to end the year at a record high.
As I discussed in a previous column, emerging markets are no longer cheap. The nearly 30 per cent rise in the MSCI Emerging Market Index, the main equity gauge of developing economies, this year has pushed up the forward price-to-earnings ratio, a popular valuation measure, to its highest level since 2010, significantly reducing the valuation gap vis-à-vis European stocks.
More worryingly, spreads, or the risk premium, on emerging market corporate debt have narrowed dramatically over the past year and are now at the tightest levels since the global financial crisis, according to JPMorgan. The sharpest compression in spreads, moreover, has occurred in the high-yield, or sub-investment grade, segment of the market, with spreads on Emerging European and Latin American “junk” bonds only several basis points above their historical lows.
Given these mounting risks, Citigroup is right to ask, as it did in a note published last month, whether “this is as good as it gets” for developing economies?
While there is no question that the trio of vulnerabilities in emerging markets – stretched valuations (particularly in debt markets), the threat of a Fed-induced tightening in global financial conditions and the risk of a marked slowdown in China’s economy – increase the scope for a sharp correction in asset prices in 2018, the bar to a disorderly sell-off remains high.
For starters, unlike previous emerging market crises which were home grown, the current threats to the asset class are external. The economic fundamentals of most developing economies have improved significantly since the 1997-98 Asian financial crash, so much so that emerging markets have weathered numerous shocks over the past several years – the 2013 “taper tantrum”, a plunge in commodity prices and the fallout from the August 2015 surprise devaluation of the yuan – relatively well. Citigroup even goes so far as to describe emerging markets as “crisis-proof”.
This is almost certainly an exaggeration given the extent to which emerging markets have benefited from leading central banks’ ultra-loose monetary policies. What is not an exaggeration, however, is the fierceness of the “grab for yield” among investors at a time when roughly 20 per cent of the global stock of sovereign bonds is negative-yielding. Make no mistake, there is still enormous appetite for higher-yielding emerging market assets.
Thirdly, although a source of increasing nervousness in markets, further tightening by the Fed and China’s crackdown on shadow banking are unlikely to cause investors to panic, largely because both countries’ central banks are wary of crimping growth.
All this suggests that emerging market investors will remain shaken but not stirred. Returns in 2018 will not be half as juicy as they were this year, but the rally in developing economies still has legs.
Nicholas Spiro is a partner at Lauressa Advisory