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Emerging Market Viewpoints – January 2019

Wednesday, January 30, 2019

Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team

Are Emerging Market equities becoming less risky in relation to developed markets? If one were to look purely at debt to GDP ratios, savings ratios, political stability and the level of domestic interest rates a fairly strong case could be made that our asset class looks as good, or better in a number of cases, than the U.S., Japan and Europe.

If the level of short term (one year) interest rates is any guide then companies in Taiwan (70 basis points), South Korea (1.7%) and Thailand (1.8%) are already able to borrow at interest rates lower than their U.S. (2.5%) counterparts. These three countries alone represent over a quarter of the Emerging Market equity universe.

In regard to government debt to GDP ratios, almost all emerging markets look better than the developed markets. Japan with a debt to GDP of 253% stands out in this area, followed by the U.S. at 105% and the Euro area at 86.7%.

By contrast, supposedly “high risk” countries such as Russia (19.0% of GDP), Mexico (46.4% of GDP) and Indonesia (30% of GDP) look relatively unleveraged. Even Brazil (74% of GDP) and South Africa (53.1% of GDP) look less leveraged than the developed markets. The markets of Asia ex- Japan look especially good in this regard, with Korea (38% of GDP), Taiwan (31% of GDP) and China 47% of GDP).

The main difference between the emerging and the developed markets is that the latter borrow almost entirely in their own domestic currency. Many of our markets such as Russia and Brazil that have gotten into trouble in the past due to large amounts of foreign currency loans, have significantly reduced their dependence on external funding. The two markets that are the biggest exception to this trend (Argentina and Turkey) are also the two markets with the lowest savings ratios and the highest borrowing costs. As a result, they are also the most sensitive to a change in U.S. interest rates.

At first glance China’s government debt to GDP ratio of 48% does not look especially high. This ignores the level of private sector debt, particularly in the corporate sector, which is over 150% of GDP. This remains a key vulnerability for the emerging market asset class, particularly the large amount of U.S. dollar borrowing by companies with only renminbi revenues. For this reason it should come as no surprise to investors that the Chinese authorities are doing everything they can do get their domestic corporate and government bond market included in the relevant Global indices.

From a monetary policy perspective the emerging market asset class is also looking better on a relative basis. Central Bank independence is now very well established in most of our markets, with the exceptions, such as Turkey, forced by the market into more prudent policies. Although there are concerns that the Indian government is too involved in the setting of monetary policy, this has stopped short of Prime Minister Modi sending out Tweets calling for lower interest rates.

And finally from a fiscal perspective most emerging markets look downright frugal in comparison with their developed market counterparts. Even an avowed leftist such as AMLO in Mexico has vowed to keep the fiscal deficit of to less than 1.0% of GDP. Japan’s fiscal deficit is expected to be approximately 4.4% of GDP this year, with very little doubt that this will be monetised by the Central Bank.

The fiscal deficit in the U.S. of 4.0% of GDP, or approximately U.S. $1 trillion, is even more concerning given the recent strength of the economy Even more worrisome is that a Presidential election is next year and that usually means an increase in fiscal spending. Traditionally the Republicans are seen as more fiscally conservative than their Democratic counterparts. They have now have lost any credibility on this issue and will find it difficult to criticise a Democratic President who runs large deficits in the future.

Some Democratic candidates are already calling for massive middle class tax cuts at the same time that they are proposing increased taxes on the highest earners, including a wealth tax. When combined with proposals for universal health care and student loan write offs it is quite conceivable that the U.S. budget deficit could easily exceed 6.0% of GDP. It is also easy to see a second term of President Trump characterised by further encroachments on Central Bank independence and stubborn fiscal deficits. We would not expect the dollar to appreciate under either scenario. Historically, a relatively weak dollar has been positive for our asset class, barring the need to raise interest rates to stem any unruly decline


IMPORTANT INFORMATION | Issued and approved by Pacific Capital Partners Limited, a limited company registered in England and Wales, authorised and regulated by the Financial Conduct Authority. TThe information contained herein is not approved for use by the public and is only intended for recipients who would be generally classified as investment professionals. Information or opinions contained in this article do not constitute an offer to sell or a solicitation, or offer to buy, any securities or financial instruments or investment advice or any advice or recommendation in respect of such securities or other financial instruments. Where past performance is shown it refers to the past and should not be seen as an indication of future performance.

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