There is a long-running narrative about emerging markets, with which most of us are very familiar. They are faster growing, more dynamic economies than in the western world. Their fabled, rising middle class is going to fuel new consumption and the development of new brands. They are, in short, the future, and the time to invest is now. Yet, since February, emerging markets have run into a bit of a brick wall, and not for the first time in recent years. What gives?
The proximate cause for concern is emerging market currencies. This is usually a sign of other problems. The JP Morgan index of EM currencies, which surged in 2017, has given up nearly all its gains, dropping to its lowest level in a year. Hardest hit have been the Turkish lira and the Argentine peso.
In fact, if you are going to Turkey for your summer holidays, you’ll be overjoyed. Your pounds will go almost 20 per cent further than you might have imagined if you had booked in January, and almost 40 per cent further than a year ago. It’s all a bit volatile at the moment because yesterday the Turkish central bank raised a key interest rate from 13.5 to 16.5 per cent, doubtless to President Erdogan’s chagrin, and the lira rallied by 5 per cent. The Argentine peso has dropped by nearly a third against Sterling since the end of last year, and by 65 per cent compared with a year ago.
It is no coincidence that among major emerging markets, Turkey and Argentina are the two with balance of payments deficits of around 5 per cent of GDP. This sort of imbalance is usually associated with financing problems at some point, and foreign investors have indeed been questioning the credibility of—or given up on—the policies being pursued by both governments.
The wider financial outlook for emerging markets nowadays tilts on an axis with Chinese economic growth on one end and United States monetary policy on the other. During much of 2016-2017, benign conditions prevailed. Chinese economic growth became more reliable and buoyant following the financial problems in that country in the prior two years, while in the US, the Federal Reserve was gingerly raising interest rates with long intervals in between.
Yet, in the year to date, it’s been a case of change.
Chinese growth is not exactly weak, but momentum has been slowing down, and the impetus provided by acceleration has dissipated. The problem in China isn’t so much with output as it is with demand. Fixed asset investment (real estate, manufacturing and infrastructure) is still up 7 per cent over a year ago, but this is the weakest rate since 2000. Infrastructure investment, which surged in 2016-2017, has been slowing down steadily as the government’s crackdown on local government spending and financing has held firm. Retail sales and exports have lost some edge, while in housing, new floorspace started and sales of land are much softer.
Perhaps more significantly at the moment, US monetary policy expectations have become rather feistier. With the enactment of significant tax cuts, mostly for companies, a more or less full employment economy has had a new boost. Economists have seen a marked firming up of firms’ capital spending, and expect the budget deficit to rise from 2-3 per cent to around 5 per cent of GDP in the next one to two years. Companies are bringing more people back into the labour force as employment conditions tighten, and several groups of workers are seeing wages and salaries pick up. These conditions have persuaded many, though not all, policy makers and market participants that the Federal Reserve will raise interest rates at least twice more this year, and three to four times in 2019. The US dollar has turned around, rising almost 5 per cent since mid-February, and US bond yields have drifted up to over 3 per cent.
Neither trend looks exhausted yet, but both of them generate balance sheet disturbances that can prove highly destabilising. Remember that emerging countries have been on a borrowing binge over the last decade. According to the Bank for International Settlements, the level of US dollar credit to non-financial borrowers in emerging markets and other developing countries reached $3.7trn last year. That is about $2trn more than in 2008. China was by far the biggest borrower in the EM universe, but Mexico, Turkey, Russia, Brazil, Indonesia and Argentina all figured prominently. So, borrowing costs are rising, and the currency in which much debt is denominated is strengthening.
As a result mainly of these factors, there has been a sharp exodus of capital from emerging market funds. According to EPFR, a financial intelligence group, and the Institute for International Finance, bond and equity outflows increased after February. They have probably been running at less than $5bn per month, which is about a third of levels seen during the last big exodus in 2013, but there is little room for complacency.
There are two other clouds hanging over emerging markets. First, China aside, the fortunes of many emerging markets are tied to the production of commodities, linked for example to China’s (weakening) housing market, or to traditional manufacturing. Advanced technologies, however, are tilting the principal sources of wealth and job creation towards richer economies, and in some respects marginalising emerging markets. Some countries such as Mexico and Brazil may have reached peak manufacturing employment at 20 and 16 per cent respectively of the labour force—far below China’s 30 per cent at its peak.
Second, even though the Trump Administration this week caved into China with respect to trade and technology, the risk of trade and investment conflict is not going away any time soon. The strong US dollar and US fiscal expansion will worsen America’s trade balance, as China’s slowing economy improves its own. The dispute over China’s industrial policies is bedded in for the longer term. As and when the commercial climate deteriorates, emerging markets will feel the chill first.