Emerging Markets Health Check
Emerging markets (“EM”) are often thought to be vulnerable to tightening cycles in the developed world. This belief is not without merit, as evidenced by the “Taper Tantrum” of 2013.
At first glance, it would appear that this viewpoint is warranted, based on the performance of EM during the latest market downturn. EM equities have fallen since the Fed began raising rates earlier in 2022. Additionally, EM headlines in recent months have focused on the rising number of countries in the developing world approaching default and the roughly quarter of a trillion dollars in distressed EM debt.
Headlines, however, can be deceiving. The struggles of EM year-to-date through September, 2022 (“YTD”) are more the result of idiosyncratic events, most notably Russia’s war in Ukraine and China’s regulatory actions and COVID policy, rather than foreign central bank activity. The relative health of the EM countries where global investors are most exposed is better than headlines would indicate.
Debt Across the Developing World
The term EM is used loosely in the global investment community. Sri Lanka, Ghana, El Salvador, Egypt and Pakistan face very serious issues and are either in, or approaching, default. However, with the exception of Egypt (0.1% weight in the MSCI EM Index), these nations are not classified as EM by MSCI, the leading global index provider and an appropriate indicator of investor EM exposure. Conversely, many of the larger EM nations such as India, Mexico, and Brazil offer more resilient balance sheets.
Since the Taper Tantrum, government debt as a percent of GDP rose less in EM (13%) than the world as a whole (17%). Debt around the world has increased more sharply in the recent two-year period as a result of the COVID-19 pandemic. From 2019 to 2020, government debt as a percent of GDP rose 9% in EM compared to a 22% increase in developed markets (“DM”).
During the Taper Tantrum, countries operating current account deficits, notably the “fragile five” of Brazil, India, South Africa, Turkey, and Indonesia, sold off sharply on the prospect of Fed tapering and sparked fears of contagion. Current account measures the balance between a country’s imports and exports. A deficit indicates a country is a net importer and more vulnerable to borrowing conditions.
After several political regime changes and years of market-friendly reform, the fragile five current accounts are now in better shape than they were during the Taper Tantrum. South Africa and Indonesia, for example, were operating at a surplus as of December 31, 2021. While others remain at a deficit, the severity is a fraction of the levels reported in 2013.
Excluding China, EM foreign currency reserves have also steadily increased over the past decade, which may help provide some cushion from future economic turmoil. It’s worth noting that China’s stockpile of reserves can skew the broader EM data. Its use of reserves has also been more volatile, particularly in response to the abrupt market crash in the summer of 2015.
Foreign exchange policy changes across many EM countries have decreased the likelihood of currency crises akin to those seen in the ’90s. Since that time, most EM currencies have moved from fixed to floating exchange rates. China is an exception; the renminbi floats in a narrow band around a fixed rate.
The Issue of Inflation
Many emerging countries responded to rising global inflation earlier than developed markets, making a hard landing presumably less likely. The U.S. announced its first 25 bps rate hike in March 2022, several quarters behind developing countries such as Korea and South Africa, which started hiking in the third quarter of 2021. Brazil, which has a history of high inflation, started hiking nearly a year ahead of the U.S. and saw peak inflation in April 2022. Brazil is likely nearing the end of its tightening cycle. China is an outlier; the Central Bank continues to ease as COVID lockdown measures continue to stifle economic growth.
Total emerging markets year over year inflation was a reported 10.6% as of June 30, 2022. While this figure is in-line with global inflation, major markets such as China and India remain well below global levels, at 2.5% and 6.2%, respectively.
The economic health of EM nations appears favorable relative to years past. However, the asset class is not without its risks, and a level of geopolitical and economic uncertainty should be assumed when investing in less nascent markets. These include, but are not limited to the following:
Financial collapse across multiple developing countries, regardless of size, prompts fear of contagion. This, in turn, could create a cascade of asset outflows from other countries deemed vulnerable.
- Geopolitical Tensions
Geopolitical uncertainty in Eastern Europe continues to pressure commodity markets as Russia’s war in Ukraine continues with no near-term diplomatic resolution in sight. Tensions between China and U.S. remain elevated, and have been stoked further by China’s geopolitical ambitions in Taiwan.
- Chinese Policy and Property Market
The Chinese economy has suffered self-inflicted pain from its draconian zero-COVID policy and regulatory crackdown on its large internet, tech, and ecommerce companies. President Xi Jinping secured a third term at China’s Party Congress in late October. In doing so, he also further consolidated his power, which sent chills through the global market, as investors questioned his dedication to economic growth and willingness to ease his economically destructive policies.
The Chinese property sector remains heavily in debt, and its issues have been exacerbated by slowing growth and weaker consumer confidence. The Chinese government’s capacity and willingness to intervene long-term remains unknown.
Former President Luis Inacio Lula da Silva (“Lula”), who was previously jailed on corruption charges after two terms, defeated incumbent President Jair Bolsonaro in Brazil’s run-off election in late-October. Lula was elected on a leftist agenda, however he offered little insight into his economic policy during his candidacy. Bolsonaro has been highly vocal, claiming the election process was fraudulent, leading to concerns that the transition of power could be contested and lead to heightened market volatility.