When the easy money ends
So far, 2018 has been a tough year for emerging markets. EM bonds and currencies have posted steep losses year to date. The most recent bout of weakness was triggered by Turkey’s political and economic problems, but the declines have rippled throughout the emerging market universe, and even to a few developed markets. While the pace and magnitude of the recent selloff has been surprising, the downtrend itself isn’t. We’ve been concerned about the potential for weakness in emerging markets since late last year, when we suggested investors consider underweighting EM bonds in their portfolios.
Most Emerging Markets Currencies are down against the U.S. dollar year to date
Source: Bloomberg. World Currency Ranker (WCRS) Date range 12/29/2017 to 8/17/2018.
One of our key themes heading into 2018 was that “the era of easy money is ending.” It marks a turning point for the markets. With central banks in developed countries shifting away from zero or negative interest rates and phasing out their bond-buying programs, financial conditions are getting tighter. As a consequence, prices for riskier assets that had benefited from ultra-low interest rates are repricing as rates move up. As EM bond yields were at or near all-time lows earlier this year, it seemed very likely that continued Fed tightening would trigger a correction. To date in 2018, the total return has declined by 3.6%, reflecting weakness in currencies as well as in bond prices.
Bloomberg Barclays Emerging Market USD Aggregate Index has declined this year
Source: Bloomberg Barclays. Daily data as of 8/20/2018.
As with past financial crises, the underlying problem in the EM bond market is too much debt, especially debt denominated in U.S. dollars.
U.S. dollar-denominated corporate credit by region
Source: Bank for International Settlements, June 2018
Although many countries have borrowed heavily over the past decade, it’s the corporate sector borrowing that stands out. Taking advantage of low interest rates and a strong investor appetite for yield, companies in EM countries more than doubled their borrowings in U.S. dollars since 2007. The Bank for International Settlements estimates that the debt of non-financial companies has increased from $1.5 trillion to $3.7 trillion. With the dollar moving up sharply over the past few years as the Fed tightened monetary policy, repaying the debt will likely be increasingly difficult for many of these borrowers. For example, the Turkish lira has dropped by nearly 50% recently, which means that dollar-denominated debt issued by Turkish companies has nearly doubled. Servicing that debt will clearly be difficult, and consequently corporate defaults could rise, putting a strain on banks that have made loans to these borrowers.
Much of the increase in dollar-denominated debt has come from companies in China. About 19% of the Bloomberg Barclays Emerging Market USD Aggregate Index is represented by Chinese issuers. With China’s economy slowing, the yuan edging lower, and the trade conflict with the U.S. ratcheting up, it wouldn’t be surprising to see bonds downgraded and/or an increase in defaults. Other Asian emerging markets that are linked to China through trade and investment may also slow.
Bloomberg Barclays Emerging Market USD Aggregate Index by country of issuer
Source: Bloomberg Barclays. Data as of 8/15/2014 and 8/17/2018.
However, the most fragile of the EM countries are those with the highest levels of external debt. Even though problems in Turkey have been at the forefront of the recent market turmoil, other countries have similar vulnerabilities of high external debt levels and softening growth. Currencies of many of these countries, such as South Africa and Brazil, have already fallen sharply, which could cause investors to retreat from the asset class more broadly.
External debt as a percent of gross domestic product (GDP)
Source: International Monetary Fund, World Economic Database, April 2018.
Valuation is only one piece of the puzzle
While the recent selloff has made EM bonds and currencies more attractive for U.S. dollar-based investors, we are cautious about upgrading our view of these markets. The long-term factors behind the selloff—tightening monetary policy by the Fed, high debt levels in many EM countries and trade turmoil—are still intact. Moreover, valuations haven’t reached levels that are comparable to prior EM declines. The interest rates spread between EM bonds and U.S. Treasuries has increased, but is still below the long-term average of 3.7% and the peak levels of 4% to 5% seen in recent years. In light of the risks in the market, we would like to see higher yields relative to U.S. Treasury yields before taking more risk in these markets.
Bloomberg Barclays Emerging Markets USD Aggregate Bond Index is below its long-term average of 3.7%
Source: Barclays Emerging Markets USD Aggregate Bond Index, monthly data as of 8/17/2018.
What to watch
In addition to monitoring valuations, we are waiting to see how currency weakness and/or high debt levels in EM countries are addressed before changing our view. To date, a few countries have taken steps to raise interest rates to stabilize their currencies, but in some cases more will need to be done. Also, trade conflicts still loom. Many EM economies are heavily reliant on trade for growth.
In our view, investors still aren’t getting enough compensation for the risks of investing in EM bonds in the form of extra yield, especially at a time when the Federal Reserve is accelerating its tightening in monetary policy, making U.S. bonds relatively more attractive and potentially pushing up the value of the dollar. We’re going to stay with our suggestion to underweight EM bonds for now.