Emerging market assets are under pressure due to a stronger USD and higher US rates, as well as due to medium-term challenges
Investor sentiment improved on the back of weaker-than-expected US inflation data that alleviated concerns about a more aggressive rate tightening cycle by the Fed (see Economics). The MSCI Developed Markets equity index was up by 2.0% wow (+1.4% YtD), with the Energy sector the main driver (3.2% | +6.1% YtD) following the US decision to withdraw from the JCPOA deal (and impose sanctions on Iran) which boosted oil prices to $77/barrel – their highest level since 2014.
Emerging market (EM) equities also improved, following three consecutive weekly losses, as US 10-Year rates and the US Dollar interrupted their upward trend. Note that all EM assets (Equities, rates, FX) have corrected significantly since mid-April on the back of the strength of the USD, trade tensions and idiosyncratic factors (Turkey, Argentina – see below).
Indeed, EM currencies have depreciated by circa 4% (JPM FX index) and EM equities have declined by 1% in USD terms (+0.6% in local currency). Moreover, local currency Government debt has returned -1.2% (GBI-EM index and -5.4% in USD terms), USD-denominated Government Debt -2.2% (EMBIGD index) and USD-denominated corporate debt -1.3% (CEMBI index), with spreads widening by 20 bps to 30 bps during the same period (see graph page 3).
The correction of EM assets may appear exaggerated as EM GDP growth remains strong, with the IIF GDP tracker of 5.9% close to its highest level since December 2011, inflation (with the exception of Turkey and Argentina) remains close or below central bank targets and asset valuations are not elevated.
The medium-term outlook, however, appears unfavorable, with several downside risks; protectionism is gaining pace and could hurt trade and growth prospects for emerging markets, the heavy political calendar (Turkey: June, Mexico: July, Brazil: October), and tighter global financial market conditions – possibly triggered by a reassessment of the Fed’s rate tightening cycle along with the sustained strength of the US Dollar – could prompt capital outflows from emerging markets.
Investors should favor EM countries with low current account deficits, low external refinancing risks and high reserve adequacy, a low percentage of public debt denominated in FX currency and inflation near or below central bank targets (see our scoreboard below).
In Argentina, the central bank raised its benchmark policy rate cumulatively by 12.75% since end-April to 40% in order to halt the ARS depreciation (Argentinian Peso/ARS: -22% since end-April against the US Dollar to $24.67 | -34% ytd) due to current account deficit deterioration (4.8% of GDP in 2017 compared with 2.7% of GDP in 2016) and rising inflation (25.4% yoy in March).
Argentina’s non-financial corporates are exposed to currency devaluation risks (via higher debt servicing costs), as circa 40% (6.4% of GDP) of their debt is denominated in USD. Moreover, a large part of Argentina’s public debt is denominated in foreign currency (68% of total). Therefore, financial assistance was requested from the IMF under a Stand-By Arrangement (SBA) facility. Argentina’s government bond yields stabilized (5Yr: -23 bps wow to 18.71% | +260 bps ytd), while equities rebounded by 4.5% wow (-0.7% ytd) (see page 3).