26 March 2021

President Erdogan’s decision to sack Turkey’s central bank governor Naci Agbal last week following the CBRT’s decision to raise interest rates 200bp has increased volatility in EM currency markets. Is this just the latest episode of Turkish political intrigue? Alternatively, given both Brazil and Russia also lifted key rates, has a more systemic risk to Emerging Markets arisen? Indeed, after outperforming during most of the past year, EM equities have slumped in recent weeks. As the global environment has become somewhat less favourable, increased scrutiny of the macro-fundamentals of individual EM countries is increasingly important. Overall, I still believe EM assets will outperform during the next 12-24 months. And, I offer a roadmap to to help differentiate between the winners and the bad apples.

American Rescue Plan: Shifts Global Goalposts

In a recent blog “Global Fiscal Policy: Keeping the Pedal to the Metal” I assessed the implications of President Biden’s American Rescue Plan (ARP). Prior to the program’s announcement, financial markets expected global GDP to recover, US inflation to remain tame, the Federal Reserve to remain on hold, near-term rises in US bond yields to be modest, and the US dollar to weaken. The sweet spot for EM investing.

America’s massive fiscal stimulus, however, has altered this benign global market environment by adding to US (and global) inflation and interest rate risks. EM investors, therefore, must anticipate both by how much US bond yields are likely to rise, and how quickly. To be sure, an abrupt rise in US yields would damage sentiment in all high-risk assets. In the earlier blog, I suggested that the recent selloff in the US bond market so far is following the pattern of previous economic cycles (Chart above). Therefore, I expect US inflation will breach the 2% threshold by the end of 2022, and the Federal Reserve will delay rate hikes until well into 2023. Under these conditions, the US yield curve will steepen further, and 10-year yields will rise gradually towards 2.5% by the end of next year.

Moreover, higher nominal and real bond yields, however, may limit US dollar risks in the near term. However, larger government deficits could lead to a doubling in the size of America’s current account shortfall (towards 5-6% of GDP) in the next few years; adding to medium term vulnerabilities for the green back.

On the other hand, EM nations will benefit from stronger global growth resulting from America’s expansive fiscal program (Chart above). Asian nations will benefit from strong global industrial production, while Latin America will be lifted by additional gains in commodity prices (Chart below). Overall, therefore, the ARP creates addition uncertainties for Emerging Markets. However, if the rise in US inflation and bond yields is orderly, these risks may be offset by stronger global economic expansion.

External Financing Needs: Spotting the Bad Apples

The EM countries most vulnerable to rising US bond yields (or heightened risk aversion amongst investors) are those will large external financing needs. Specifically, nations with bloated current account deficits and large short-term external borrowing requirements encounter problems rolling over these debts. The Chart below indentifies the usual culprits: Turkey, South Africa, Brazil, and sometimes India, Indonesia, and Hungary are added to the discussion. However, it’s important to observe Turkey’s exceptional position, given it’s enormous stock of short-term foreign indebtedness.

In 2020, the pandemic led to an overall reduction in global capital flows, including an especially sharp decline in Foreign Direct Investment. Recent trends in foreign exchange reserves provide additional evidence regarding each country’s ability to attract needed international financial inflows (Chart below).

Once again, Russia and East Asia are rock solid (in large part reflecting current account surpluses). India’s experience has been particularly remarkable. At the other end of the spectrum, Turkey (especially), Argentina, Brazil, and South Africa have witnessed a small dip in their central banks’ external reserves.

Central Bank Credibility: Hard Won, Easily Lost

Numerous factors contribute to a nation’s ability to attract the foreign capital it needs. Not least among these is the perceived credibility of macroeconomic policy decision-making. In particular, are the nation’s institutions robust enough to consistently pursue its financial objectives? To be sure, one could write a book on this topic. Within the EM universe, however, even some of the more vulnerable countries, e.g. Brazil and South Africa, enjoy high monetary policy credibility (e.g. well established inflation-targeting regimes). Brazil’s Achilles heel is its unstable fiscal policy, and RSA maintains an insufficient level of FX reserves.

Mexico, Chile, Taiwan, Korea, and Poland also enjoy solid credentials. Russia, China, India, and Indonesia (amongst others) are just beginning to earn their stripes. Argentina and Turkey are the other extreme. Turkey’s nascent commitment to inflation-targeting is lukewarm at best. Indeed, President Erdogan often suggests that higher interest rates lead to inflation! Regular political interference reduces the CBRT’s independence. Recent developments have dashed any merit gained by last Autumn’s monetary tightening. Hard won, easily lost……gone for good?

Policy Credibility: Are Economic Cycles In Sync?

Another aspect of credibility is whether the nation’s macro decisions are consistent with overall policy objectives. Currently, for example, should monetary conditions be tighten if rising US inflation and bond yields are creating FX market volatility? Yes, but only if domestic economic growth and inflation cycles are in sync with America’s. However, the Chart above suggests this might not be the case at present. The massive US fiscal stimulus will eliminate its “output gap” (high unemployment and unused capacity) by the end of 2022. The OECD calculates the global output gap still will exceed 2% at the end of next year, and will be far higher in many EM countries.

As a result, while US inflation will accelerate, price pressures remain low in most EM countries (Chart above). However, there are important exceptions. Somewhat ironically, Turkey’s decision to raise interest rates was appropriate: economic slack is declining and inflation rising. Nevertheless, Governor Agbal lost his job.

Likewise, while the decisions in Russia and Brazil were surprising, higher rates may have been warranted, as inflation is rising and monetary conditions remain extremely accommodative (following Chart). Although both central banks indicated further rate hikes remained possible, Brazilian rates should remain low, as inflation largely reflects only higher food prices (core inflation remains well below target).

Elsewhere, currency volatility could lead to tighter policy in the Philippines and India, although large output gaps suggest core inflation risks are manageable (headline prices could rise as food costs spike). The absence of inflation and large output gaps would make higher interest rates inappropriate in most of Asia, Latin America, and South Africa. Indeed, despite recent FX volatility, Mexico’s decision to cut interest rates today reflects the implications of unsynchronised economic cycles. In this environment, if necessary to ensure economic recovery takes hold, these nations should maintain low interest rates and accept a modest degree of currency weakness.

Covid Experience: Favours Asia, Despite Poor Vaccine Rollout

The EM economic outlook will remain uncertain until the Covid pandemic is under control and populations are vaccinated. While Asia’s vaccination track record is poor, the low level of infection has paved the way for economic recovery. Similarly, with the exception of Chile, Latin America’s rate of vaccination remains alarmingly low, especially against the backdrop of an undeniable third wave of the pandemic, especially in Brazil.

Strategic Considerations: Pulling the Pieces Together

• Turkey’s monetary policy credibility has been severely compromised again. Additional rate hikes may well be required to stablise inflation and TRY. Will the incoming CBRT Governor be willing to do so? TRY risk remain. Turkey will add to market volatility, but should not pose systemic risks to EM investing (fingers crossed!).
• The Chart above illustrates that Latin American currencies are very undervalued. FX downside, therefore, should be limited unless US bond market conditions become more disruptive. While the region’s Covid experience and near-term economic prospects remain worrisome, rising commodity prices will be a tailwind. However, weak economic recovery and low core inflation suggest accommodative monetary conditions remain warranted, e.g. as Mexico’s recent rate cut reveals. Chile enjoys high commodity exposure and favourable vaccination trends, but its external balance sheet is relatively weak.
• Most of Asia enjoys very low external financing requirements, tame inflation, and fairly-valued exchange rates. Until economic recovery is more firmly established, modest FX weakness should be tolerated if necessary. Monetary conditions in the Philippines could be tighten as inflation accelerates (peso is overvalued).
• The Chinese government cautiously forecasts 6%-plus GDP growth in 2021, while I project a 9% gain. CNY risks appear limited, as the central bank has signaled a willingness to tighten policy if necessary (which I do not expect).
• I still anticipate EM (especially Asian) equities to outperform the USA during the next 12-24 months. However, the cushion provided by a large earnings yield gap (the difference between the EPS earnings yield and US bond yields) has now disappeared. The Chart below, however, does reveal a still-attractive dividend yield gap (a key Asian valuation metric historically). As a result, future corporate earnings growth will be the key driver of EM equity market performance. EM consensus EPS growth of 30% and 15% in 2021 and 2022 compares favourably to the S&P 500’s 22% and 10% respectively (thanks to Morgan Stanley for the Charts below).