August Emerging Markets Update

Monthly Commentary

August 16, 2019

The macro outlook is dominated by three themes—global growth slowdown, central bank easing and U.S./China trade tensions. Year to date, growth in the U.S. has been on a slowing trend while growth outside the U.S. has continued to disappoint. A confidence shock from the escalating trade war in March derailed the recovery in China, while European business confidence has been weak. Consecutive U.S. monetary and trade policy surprises—a more hawkish Fed1 on July 31 and U.S. tariff announcements on August 1—have further hampered the outlook for global growth and injected considerable volatility and uncertainty into markets.

To compensate, global central banks are easing as they face an asymmetric policy outlook—inflationary pressure has been muted, while risks to growth have mounted. Lower U.S. rates are quite positive for Emerging Markets (EM) central banks, providing them more room to maneuver to support growth. We have already seen rate cuts in Brazil, South Africa, Indonesia, Thailand and India taking advantage of this dynamic.

Conversely, we are concerned about the reescalation of trade tensions. While U.S. firms have managed to offset a meaningful portion of earlier tariffs by reworking supply chains and front-loading orders, indications are that the latest round would be substantially harder to offset and will likely either need to be passed through to the consumer or absorbed in profit margins, both of which would dent the U.S. (and global) growth outlook. The uncertainty also has ramifications for capex and the investment cycle in the U.S. and China, to which Asian economies are particularly exposed. While our base case is for the U.S. to proceed with additional tariffs, there is still a possibility of the U.S. and China reaching some sort of truce before the latest round of tariffs takes effect in September, although the outlook is bleak as talks have deteriorated.

That being said, while the trade standoff could have meaningful repercussions for growth and risk sentiment, the impact would likely be partly offset by a more dovish Fed and additional stimulus in China. Should the $300mm in additional tariffs go into effect on September 1, we believe the Fed will ease by an additional 50 basis points (bps) in 2019 as opposed to 25bps should they not. In either scenario, we anticipate an additional 50bps of Fed policy easing in 2020. We also believe the Chinese government will focus on targeted stimulus—centered on improving the composition rather than overall volume of credit—and believe that the economy is still positioned to achieve 6.0% growth in 2019 (5.75% to 6% for the second half).

There are a number of EM markets with idiosyncratic drivers that make them more insulated against the U.S./China trade and global growth dynamic. Key among them are Latin American economies that represent major components in the index, like Brazil, where assets are supported by the ongoing pension reform. Following the passage of pension reform an improved outlook for debt sustainability will give BCB2 more room to ease. North Asian economies, on the other hand, are more exposed to the negative repercussions of the U.S./China trade dispute and its impact on the investment cycle.

In August, an unexpected result in the Argentina presidential primaries has sent shockwaves through the markets and led to an extreme bout of volatility in Argentine asset prices—the ARS3/USD depreciated by 15%, external debt fell by 26% (spreads increased by 600bps), and the local stock market declined by more than 35% in the immediate aftermath. While the result caused some spillover into EM high yield assets, the volatility has been generally contained and largely abated by the second trading day post-election.

In this new environment, we believe EM hard currency assets will outperform local currency in the near term. The case for EM hard currency assets remains compelling as the significant carry and valuation advantages continue to drive inflows into the asset class. As of 8/14/2019, EMBI GD spreads have widened 50bps since the July 31 Fed announcement to 369bps and is now trading on a like for like basis (adjusted for the addition of higher quality GCC4 countries this year) at levels close to 395bps, 45bps wide to long term averages. The index also yields 5.4% in an environment where 73% of investable global fixed income yields less than 3%. Supply dynamics are supportive as well, with limited net supply expected for the balance of the year as EM sovereigns exercise liability management and shift more financing into local markets.

We are more cautious on local currency debt. While we wait for greater clarity on the trade outlook, we will focus more on idiosyncratic stories with lower correlation to broader EM asset performance. We are also reducing exposure to markets with high FX volatility and those more vulnerable to capital outflows (e.g., Indonesia) Headline risk and general market volatility are likely to be higher in coming months given the change in the global macro backdrop and rising trade tensions. A number of major political events—e.g., Hong Kong protests, India/Kashmir, Iran and North Korea—could also weigh on risk sentiment, especially in Asia, where we maintain an underweight.

1 Federal Reserve

2 Brazil Central Bank;

3 Argentine peso;

4 Gulf Cooperation Council: a political and economic alliance of six Middle Eastern countries (Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman)


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