November Emerging Markets Update

Monthly Commentary

December 12, 2018

November was characterized by a sell-off in oil and equities and increasing concerns about slower U.S. growth. The market started to turn near the end of the month on perceptions of a more dovish Fed, as well as constructive sentiment leading into the G20. Performance across major global asset classes was mixed, with both safe haven USTs and select risk markets (EM equities and EM local currency) rebounding as Fed rate hikes started to get priced out. Developed market high yield, and to a lesser extent, EM dollar-sovereign debt, underperformed as spread widening outpaced the UST rally.

November Returns

Source: TCW, Bloomberg

Emerging markets dollar-denominated spreads are now around 400 basis points (bps), which is ~140 bps wide to this year’s tights and 60 bps wide to their long-term median. Emerging Markets (EM) local currency debt has borne the brunt of the weakness this year, as typically, a pickup in U.S. growth relative to other parts of the world tends to benefit the dollar. We certainly see value at current levels (yields of over 6% for investment grade risk), and believe 2019 could present opportunities to add local currency exposure if dollar strength begins to wane. We believe that the dollar could be vulnerable as the spread between growth in the U.S. and the rest of the world begins to narrow (on the back of lower U.S. growth) and the market turns its attention away from cyclical factors and starts to focus more on structural issues (rising U.S. current account and fiscal deficits). Notably, rising twin deficits have generally been a long-term driver for a lower USD.

Twin Deficits Will Drive the U.S. Dollar

Source: Citi, Bloomberg; Data as of November 30, 2018

China remains key to a turnaround in EM in our view. We lowered our growth forecast for 2019 to 6% from 6.25%, and expect a sharp drop in exports in the new year, but do not envision a hard landing. China has eased both monetary and fiscal policy, more recently implementing tax cuts and allowing for more local government issuance for infrastructure. We believe we will start to see the impact of these measures in the next six months.

Looking more broadly, the EM outlook is less uniform than before with some large EM economies slowing into 2019 (e.g. China and Turkey), others accelerating (e.g. Brazil and South Africa), while many look to be relatively unchanged to moderately slower (e.g. India, Indonesia and Russia). Most EM central banks are in tightening mode, in large part in response to the Fed’s1 tightening cycle. For many, however, it remains a gradual process, which is unlikely to significantly impair growth prospects. In addition, inflation remains at low levels, and the spread real rates in EM versus Developed Markets (DM) is near the wide end of the range. Furthermore, in our view, the spread between EM growth over DM growth will widen modestly over the next year, driven by stable EM growth versus slower U.S. growth. This structural differential has historically benefited Emerging Markets, with the strongest capital inflows correlating with a widening differential between EM-DM growth.

The gradual shift in G32 monetary policy to across-the-board QE3 tightening represents a risk capital flows into those EM sovereigns with greater external imbalances and dependence on dollar funding (i.e., Turkey, Argentina). However, we would argue that both are idiosyncratic, that Turkey is not the norm, and Argentina has been taking proactive measures to stabilize its economy. For the broader asset class, fundamental vulnerability has declined on the back of various structural reforms and currency devaluations. Average public debt/GDP for Emerging Markets is around 50%, which compares to over 100% for the developed world. In addition, the bulk of sovereign debt is denominated in local currency, rather than dollars. Furthermore, EM’s dependence on cross border bank lending has declined given a deepening of EM financial institutions and local capital markets.

Trade tensions with China have weighed on markets. Market euphoria post the G-204 was short-lived as it became apparent that both the U.S. and China remain far apart on key issues, making any rollback of existing tariffs unlikely and sustaining the risk that negotiations fail and tariffs rise further in 2019. We do not see a near-term solution, and believe trade relations will remain tense as the U.S. moves to limit Chinese imports of, and direct investment in, U.S. technology, and China will accelerate its efforts to limit its dependence on U.S. supply chains. We would note, however, that the short-term economic hit should be manageable, as both the U.S. and China are large economies that are much more dependent on domestic than external demand. And as mentioned, we believe that we should see the impact of China stimulus in the data over the next six months. Furthermore, technical positioning in the dollar is long now versus short at the beginning of the year.

EM debt overall now comprises close to 20% of global fixed income, with many investors underweight. Notably, investors with zero to minimal allocations to EMD have been taking advantage of the 2018 downtrade to add exposure. Anecdotally, our EM business has grown from $11.5bn at the beginning of the year to $14.6bn, with various upcoming mandates funding over the next few months across both hard and local currency debt.

1 Federal Reserve

2 The world’s three leading economic blocs, the U.S., Japan and the EU

3 Quantitative Easing

4 The G20 is an informal group of 19 countries and the European Union, with representatives of the International Monetary Fund and the World Bank.


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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW