Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
The continued rise in U.S. dollar interest rates is now beginning to have a significant impact on those markets that have been most dependent on external financing. This in turn has created a negative perception of the entire Emerging Market asset class. Is this correct?
We have consistently warned that should U.S. interest rates rise, the Turkish Lira would, without doubt, be the worst performing emerging market currency. By virtue, or lack thereof, Turkey has one of the lowest domestic savings rates in the world – it stands at 14% of GDP. As a result it is very dependent on external capital in order to finance its fiscal and current account deficits, the latter now exceeding 6.0% of GDP.
Over the past year the government has been pursuing a very stimulative fiscal policy, with the aim of increasing bank lending, which has now slowed to a growth rate of 18%, down from well over 20% last year. With foreigners owning almost a quarter of the domestic Turkish bond market, it is no surprise they have been heading for the exits. To make things even worse, Turkish private sector external debt is 40% of GDP, the highest in the emerging market universe. If investors anticipate that the government will pursue more prudent economic policies going forward then they are being naively optimistic. We believe the risk of capital controls is rising and would warn any investors in this market, particularly in fixed income securities, to exit immediately.
If the meltdown in Turkey, where the currency has declined by over 25% this year, is not enough to get investors more cautious on our asset class, the Argentine peso has collapsed by a similar amount just over the past month. Argentina’s problems are similar to Turkey with a very low domestic saving rate, a current account and fiscal deficit and an overdependence on external financing. The main difference is one of governance.
Argentina has taken aggressive action in response to the peso’s decline by raising short term interest rates to 40% and proposing to further reduce the country’s fiscal deficit. As a result of these actions the fund took profits on its short position in Argentina. Despite the quality of its response and Argentina probably now having its most responsible government in the last 100 years, we remain cautious on the market.
In a world where devaluations are generally deflationary- the rate of domestic inflation is less than the decline of a particular country’s currency- a lot of expenditures by the Argentine government are still subject to indexation, despite the recent passing of a pension reform bill. As result, the country does not gain as much of a competitive advantage from a depreciating currency as Brazil or Mexico for example. Our concern regarding Argentina, that equities are unattractive given their high cost of capital, remains valid despite the 20% U.S. dollar decline in the index this year. It is difficult to make a positive call with interest rates as high as 40%, making fixed income investments quite a bit more attractive than equities.
From an equity market perspective, neither country is very consequential (Turkey is now less than 1.0% of the MSCI EM index and Argentina is considered a frontier market). The major impact is potential contagion to other markets. Although Brazil, and to a much lesser extent Mexico are negatively affected by higher rates, the impact is significantly lower than in the past. Thanks to Trump’s rhetoric (cheaper peso) and stimulative economic policies (stronger U.S. economy), Mexico’s current account deficit was less than 2.0% of GDP last year. Brazil’s current account deficit of less than 0.5% of GDP was its lowest in ten years. More important for these equity markets are their upcoming elections (in July in Mexico and October in Brazil), as well as progress in re-negotiating Nafta for Mexico.
The other markets that are traditionally negatively impacted by higher U.S. rates are Indonesia and South Africa. Both have also seen a significant decline in their current account deficits over the past few years. In Indonesia’s case it is was less than 2.0% of GDP in 2017.
Asia ex- Japan now accounts for 74% of the MSCI EM index, with China, Taiwan and South Korea alone accounting for 58% of this total. All of these countries have current account surpluses - in Taiwan’s case it is greater than 15% of GDP. As a result they can fund themselves from internal resources, making them a lot less vulnerable to higher U.S. interest rates.
Despite this fact, when domestic interest rates in countries with current account surpluses fall below those of the world’s reserve currency it does have an impact on flows. For this reason we have hedged the currency of our long book in Taiwan, where one year rates are close to 2.0% below those in the U.S.
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