Our Company and Sites
June 2018

Emerging markets: Keep an eye on dispersion

Christopher Dhanraj
Director
Head of iShares Investment Strategy

Tighter global financial conditions and geopolitical unrest have hit emerging market (EM) assets recently. We still favor the asset class and believe that the drawdown presents buying opportunities. However, not all EMs are alike, and with dispersion likely to rise, the current environment gives investors an opportunity to favor (or be cautious on) individual countries.

Key points:

  • We still favor emerging market (EM) equities and see recent poor performance presenting buying opportunities. Rising interest rates, a rebound in the U.S. dollar, and tighter financial conditions are challenging EM countries with external vulnerabilities. Dispersion among emerging markets (EMs) is likely to continue rising if these trends remain intact.
  • Investors should understand the different country exposures across broad EM equity and EM debt allocations as country fundamentals are likely drivers of relative performance going forward.
  • We favor EM equities over debt, and EM Asia and Brazil in particular. Within debt, we favor hard currency EMD given improving valuations relative to local currency EMD and developed market credit.

Overview

Robust corporate earnings support our preference for EM equities and we see limited scope for a full-blown trade war. In short, we believe they offer value in a world where value is scarce. As we discuss in Emerging markets: Keep an eye on reform, we favor Brazil, China, Indonesia and India while monitoring reform efforts that are critical to the longer-term prospects.

Still, financial conditions have highlighted macro imbalances and external funding needs across countries, most notably in Turkey and Argentina. Geopolitical uncertainty, including upcoming elections in Mexico and Brazil, has also contributed to elevated currency volatility. For more on the political risks in Latin America, particularly with respect to growing populism trends, as well as other global risks, check out the new BlackRock geopolitical risk dashboard.

In our view, contagion risks remain limited as currency markets have already begun to differentiate among countries while the broader global outlook remains supportive of EM assets. EM country dispersion is likely to rise further as investors reassess each country’s external funding needs and political risks (see Figure 1) giving investors an opportunity to take more granular views versus broad exposures and potentially improve returns. Below we explore how a shifting global macro backdrop is affecting country risks and opportunities in key countries across the EM landscape.

Figure 1: Broad EM selloff but external macro fundamentals are driving dispersion

EM vs. DM relative performance

EM vs. DM Relative Performance

EM FX

EM FX

EM vs. DM Relative Performance

EM vs. DM Relative Performance

EM FX

EM FX

Source: Thomson Reuters, BlackRock Investment Institute. May 21, 2018. Indices shown include MSCI Emerging Markets Index in U.S. dollars vs. S&P 500, J.P. Morgan EMBI Global Diversified vs. Barclays U.S. Corporate High Yield, and J.P. Morgan Emerging Markets FX Index. Current account (CA) deficit countries include Turkey, South Africa, Indonesia, India, and Brazil. CA surplus countries include Hungary, Russia, Philippines, South Korea, and Malaysia. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

 


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Argentina: The Argentinean Central Bank (BCRA) recently hiked interest rates by 1,275 basis points (bps, or 12.75%) from 27.5% to 40.0% in a matter of a few days. Moreover, it has spent close to $6.5 billion in FX interventions since late April in a failed attempt to support the currency, ultimately leading the Administration of President Mauricio Macri to request a $30 billion flexible credit line (FCL) facility from the International Monetary Fund. The sudden reversal of fortune is forcing fiscal budget cuts, tighter monetary policy, lower growth projections, and could hurt public support for the market-friendly Macri Administration. Managing the spillover from tighter financial conditions to the real economy will be critical to containing the likely political fallout going forward.

Turkey: The combination of double-digit inflation and unemployment, an increasingly politicized central bank, a dollarized banking system, and growing twin deficits – current account deficit and fiscal deficit – are a toxic mixture keeping Turkish assets under pressure. The politicization of economic policies is worsening matters. The authorities are insistent on supporting growth ahead of the elections on June 24, 2018 despite a positive output gap. President Erdogan has promised to tighten his grip over the central bank if he wins. Turkey’s investment outlook is more likely to improve once the macro backdrop stabilizes and political inference in the central bank ends, irrespective of whether growth improves further from here.

Poland: Economic and wage growth remains strong yet the 2017 cyclical rebound in Polish asset prices is fading quickly in 2018. Local equities have fallen since January while the recent USD rally put the zloty under pressure. Poland’s weaker asset prices largely reflect the deceleration in European data, which our GDP forecasts currently suggests further downside risk. The zloty is down 8% since the dollar rally began, matching the weakness out of Brazil, Turkey, and Mexico, and politics may share blame here, too.1 Poland receives roughly 3% of GDP in European Union (EU) funds, and the EU has increased fiscal pressure on Poland in response to the Law and Justice government’s role in controversial judicial reforms. Paring back fiscal transfers would hurt growth and a political risk premium is likely to weigh on markets until an EU/Poland resolution is reached.

Mexico: Populism in Latin America is on the rise, and Mexico is no exception. Voters are looking for new leadership, and Andres Manuel Lopez Obrador (AMLO)’s Morena party remains ahead in the polls and well positioned to emerge with the largest political coalition after the July 1 elections, despite not having won a major election in over three years. The leftist candidate’s polling leads has raised investor concerns that Mexico may backtrack on key reform efforts, while recent comments from U.S. Treasury Secretary Steve Mnuchin over NAFTA have pushed backed expectations of a timely resolution into 2019.

Brazil: Despite an improving current account balance (-0.5% of GDP in 2017 versus -4% in 2014), low external debt ratio (16% of GDP), and accelerating growth backdrop, Brazil’s poor fiscal balance (-8.3% of GDP)2 has sharpened the market’s focus on Brazil’s debt service cost amid rising U.S. interest rates. Pension reform remains more necessary than ever and was meant to shore up the nation’s debt trajectory, but is on hold till at least 2019 while the October general elections move to forefront. Despite fiscal weaknesses and political uncertainty, Brazilian equities remain attractively valued at just 12.5x price-to-earnings and analysts are expecting 18% earnings growth over the next 12 months.3

Conclusion: Not all EMs
are created equal

Tighter global financial conditions have renewed the market’s focus on countries with external financing needs. Yet tighter financial conditions shouldn’t affect countries and regions with current account surpluses, like EM Asia, to the same degree it does to countries with large current account deficits, like Turkey and Argentina. To help guard against sudden reversals, investors should understand their country exposure and not overlook the risks during good times. Opportunities still exist, despite the risks and selection is key.