By Carol Lye. Regional Portfolio Manager – Brandywine Global
Slowing growth, de-globalization, and higher savings rates may warrant greater caution and selectivity with respect to emerging markets debt over the next decade.
A black swan virus shock has brought the world to its knees—dealing a particularly acute blow to emerging markets. It was only a year ago that developing markets had emerged from the previous Federal Reserve (Fed) tightening and trade war crises. Britney Spears’s “…Baby One More Time” seems like an apt description for the series of shocks that emerging markets have gone through. However, this time around both developed and emerging markets have experienced large currency depreciations as seen in volatilities. Yet this might morph into more of an emerging market stress than previously imagined. As we sit here sifting through the effects of COVID-19, we reflect on some of the stresses emerging markets may face and assess the road ahead.
Emerging Markets Under Stress
Chart 1 shows a comparative ranking of emerging market health systems, relative to one another and developed markets. With weaker healthcare systems relative to developed markets, emerging economies may be less equipped to handle a pandemic like COVID-19. India, Philippines, Poland, Turkey, South Africa, Mexico, and Brazil have issued an economic-wide shut down once they realized how critical the health crisis would be, although some were very late or too slow.
Source: Maplecroft. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Added to the health crisis was the liquidity squeeze caused by a global rush for U.S dollar cash. Even in this environment, the traditional relationship has held up, with currencies continuing to show a strong correlation to credit spreads in the U.S. (Chart 2). With the Federal Reserve (Fed) and U.S government stepping in to do whatever it takes to ease both liquidity and credit market conditions, some stress across global currencies has eased on the currency basis. To this extent, the Fed has extended swap lines to major central banks in Europe, Japan, Switzerland, Australia, New Zealand, Norway, Mexico, Brazil, South Korea, and Singapore.
Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
But even as the liquidity squeeze eases, emerging market fiscal deficits and balance sheets remain in focus. Countries globally are spending more to fill the hole left by the economic shutdowns. Concurrently with the demand shock, oil prices have collapsed, resulting in a deep revenue squeeze for many commodity-based countries. It is therefore not inconceivable that fiscal deficits will be expanded by more than twice the amount seen during normal times. Some countries can afford to do so while others simply cannot (Chart 3).
Source: Haver, Macrobond. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
It is during such times that countries need financing. Yet private capital flows have almost all but dried up. The ratio of foreign exchange reserves to gross external financing is a chart to revisit every time financial market stress accelerates (Chart 4). Clearly some countries are more vulnerable to sudden stops in portfolio flows while others have sufficient foreign exchange reserves to see it through for a year—even if banks are unwilling to roll over all short-term external debts, or investors show a buyer strike at bond auctions. The vulnerable countries after accounting for extended swap lines are Argentina, Turkey, South Africa, and Chile.
Chart 4 Note: When foreign exchange reserves fall below 1.00 to external financing needs, a country could face financing issues when capital flows stop.
Sources: Haver, Institute for International Finance. Past performance is no guarantee of future results.This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The International Monetary Fund has responded by pledging a $1 Trillion line to vulnerable countries to tide over this crisis, which has helped smaller emerging markets. The larger ones have reacted by allowing their currencies to depreciate to some extent while engaging in intervention and/or modest quantitative easing to keep their bond markets functioning with lower rates. Altogether, emerging markets have also lowered rates by some 50 to 100 basis points.
Have Currencies Depreciated Sufficiently? Who Likely Recovers First?
With currencies having depreciated by some 6% to 25% across different emerging markets, the question is whether currencies have depreciated enough such that there would be an economic feedback via the current account.
Sources: Haver, Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Looking at Chart 5 suggests that some currencies have depreciated sufficiently to counter the virus shock. One could make a judgment that the virus shock will change the economic landscape structurally, and therefore, currencies may need to depreciate further to the new norm. In light of the currency depreciations, it pays to be careful in sifting through the quality versus weak emerging markets. If a large emerging market were to default, it may cause a U.S. dollar squeeze once again across the spectrum.
Despite how gloomy the world may be now, we cannot and will likely not remain in this dismal state forever. Medicine and science are advanced and the likes of China and Korea have shown that we can overcome the virus. In envisioning a recovery, emerging markets that have a larger reliance on manufacturing exports—South Korea and Taiwan in Asia, and the Czech Republic and Poland in Europe—are likely to recover first as the China experience suggests. Many of these manufacturing economies have sufficient U.S. dollar liquidity with swap lines and no external financing issues. In the next tier of higher-yielding countries—ones with some fiscal discipline but flexibility, fewer issues with external financing needs, and credible central banks—like Indonesia, Russia, and Mexico, are perhaps likely to be able to tide over this stressful period more quickly than others.
The Long Road Ahead
The structural landscape is changing rapidly for emerging markets. As noted by my colleague Tracy Chen in her article “The Unintended Consequences of COVID-19”, there would be a reshuffle of global supply chains after the dust settles from the virus outbreak. China’s growth may slow more drastically as the major G3 economies realize the perils of supply chain concentration. However, ultimately emerging markets depend on China’s growth. Nevertheless, China’s economy will recover as the credit impulses imply, though its efforts will be focused more on investing in new technology and infrastructure, rather than piling into old-school infrastructure stimulus. Due to the virus, emerging markets will yet again engage in more borrowing leading to an even larger debt pile. Overall, the global economy will reopen slowly and in stages due to extreme caution around the virus and the potential for second-wave outbreaks. Against a backdrop of slowing growth, de-globalization, and higher savings rates globally, this may warrant exercising more caution and selectivity with respect to emerging markets over the next decade.
Legg Mason Key risks and Disclaimers
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
MeDirect Disclaimers
This information has been accurately reproduced, as received from Legg Mason Investments (Europe) Limited. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.
The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.
If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.
