A vicious cycle to a contagious virus
Emerging market (EM) weakness was in focus this month as the initial hot spots in Turkey and Argentina spread to South Africa, Indonesia and India.
They all have some combination of the classic EM risks … political instability, large foreign currency debts, structural economic issues … which are getting more scrutiny as pressures from rising interest rates and a stronger US dollar weigh more heavily.
We’re normally circumspect about the “EM contagion” narrative as it usually ends up being more headline noise than substance, but this time we’re paying closer attention because of the following;
1) US monetary policy tightening
EM had been a big beneficiary of the low interest rates, excessive liquidity and quantitative easing that prevailed post financial crisis and now this is reversing as the US Federal Reserve tightens monetary policy. While the initial catalyst for each of the EM incidents this year were idiosyncratic, the subsequent market movements have been fuelled by central bank liquidity withdrawal. This is discussed in the previous section.
2) China’s economic slowdown
While China is hardly an ‘emerging’ economy anymore, Chinese companies also took full advantage of low rates to raise a lot of foreign currency debt (mostly USD). The cost of this debt burden is rising as interest rates rise and the US dollar strengthens.
This is happening just as China’s economy is slowing, which pressures the ability of these companies to keep servicing and also refinance these borrowings.
Chinese authorities are clearly taking the slowdown seriously as rhetoric has shifted from focus on delevering, to now talking about supporting growth. Both monetary and fiscal stimulus are being deployed, but in modest amounts so far.
While the base case may be that authorities have enough control and financial firepower to keep things stable, there is currently little risk premium priced in for the downside scenario where they can’t (refer to – ‘Markets Wake Up to China Risks’ for details).
The next domino to watch is Asian credit markets. So far they’ve been reasonably well behaved but can become messy because the amount of USD denominated bonds from Asian companies has risen exponentially from 2011 (mostly China).
Ardea Investment Management