Trouble in Emerging Markets

A strengthening dollar, rising interest rates, tightening liquidity and a surge in oil prices - all are combining to create a toxic atmosphere for EM assets

EM (emerging market) assets have had a tough year to date. Whether it be currencies, rates or equities many large EMs are under pressure. We have equity markets in Brazil, Turkey and China down by 15-20 per cent. EM currencies, including now the Chinese renminbi, remain stressed. Even in India, while the headline benchmark equity indices do not show much damage, scratch a little below the surface and the damage is apparent. The mid-cap equity indices are down 20 per cent, in dollars, with many individual stocks declining by 30 per cent and more. There is serious performance pressure being faced by any portfolio management service (PMS) or fund with significant mid-cap equity exposure.

Sentiment towards EM assets has also begun to sour and we are now seeing continuous outflows on a weekly basis. Contagion fears have started reappearing.

What has put pressure on EM assets?

There are three main sources of stress. First, the rising dollar, second, rising interest rates and tightening liquidity and third, the surge in oil prices. All three factors, when combined can create a toxic atmosphere for EM assets. 

Let’s look at each. 

Oil prices are refusing to come down, seemingly having found a new equilibrium between $75-80 per barrel on Brent. My fear is that oil prices may actually rise even further from here. The Organization of the Petroleum Exporting Countries (Opec) has not raised production enough to compensate for the chaos in Venezuela, and from November, even Iranian oil may no longer be available. Interestingly, despite the surge in oil prices, the oil services index has barely moved. A high beta play on oil prices, normally with oil prices having doubled, oil service stocks should be on fire. Their lack of participation in the oil rally, indicates a limited increase in investment by the oil majors towards drilling, exploration and related capex. The oil majors are all talking of capital return, dividends and buybacks, not increasing capital expenditure. There remains a lack of clarity on whether to green light new projects, with a 15-20 year project life given the inexorable move towards electrification and renewables. With global oil demand continuing to grow by about 1.5 million barrels per day, supply remains challenged, even with US shale oil majors pumping flat out. The lack of new investment may create a supply shock. 

Surging oil prices impact liquidity as working capital needed to fund the inventory in the system increases by hundreds of billions of dollars. It will also slow down global growth and tighten financial conditions. With the US nearing self-sufficiency in petroleum, a rise in oil prices creates an imbalance in demand/supply for dollars as well.

Rising interest rates are also a given, to my mind, until and unless we get another crisis, in which case the risk-off environment will create a safe haven bid for dollar assets, especially treasuries. At 3.75 per cent, the US unemployment rate is below the full employment threshold. We now have for the first time, job openings, exceeding the number of people looking for employment in the US. The employment cost index for the private sector in the US is rising at 4 per cent. All anecdotal evidence indicates that the US economy is firing on all cylinders. The Trump tax cuts and fiscal expansion will further supercharge growth. The Federal Reserve (or the Fed) will have to continue hiking rates to cool the economy. Interest rates are clearly headed higher. There is a very clear correlation between tightening financial conditions in the US and weakening EM asset prices. 

As for the dollar, we have already seen it strengthen by 6-7 per cent, this year, even though it has barely risen on a year-on-year basis. Even this limited rise has created stress in Argentina, Brazil, Turkey and South Africa. A strong dollar has always been negative for both commodity prices and EM assets. Given that the US economy is far stronger than others in the G-7, the Fed will probably tighten faster and more significantly than other major central banks. Weakness in EM assets and rising rates will, in any case, bring flows back into the US. If markets weaken significantly, risk aversion will boost the dollar as well. Given the above, I do not see why the dollar will weaken from here and reverse course. It may be overbought and take a breather, but that is tactical, structurally dollar strength seems to be the path of least resistance.

To the above, we have to add the risks of a global trade war. EM assets are a high beta play on global trade and globalisation, both of which seem to be moving in reverse. 

The other elephant in the room is China. Clearly, it’s economy is slowing. Will it once again unleash a stimulus package, or swallow the bitter medicine of an economic slowdown to attain financial stability? In previous periods of EM weakness, China invariably stimulated its economy to protect growth. The stimulus took the form of fixed asset investment and enhanced credit flows. This stimulus cushioned both the Chinese economy as well as other EM assets, given the size of the Chinese economy and its consumption of raw materials. This time there is doubt as to whether a new stimulus package will be unveiled? Chinese policy makers seem prepared to accept lower growth to stabilise their financial system. If true, this takes away one safety net EM assets have enjoyed over the last decade. 

Given all of the above, EM assets will continue to be challenged for the time being. Unless the macro environment changes and these three pressure points were to reverse, pressure will remain on the asset class.

India may actually do better on a relative basis, despite its exposure to oil prices as it is less exposed to falling commodity prices and weakening global trade. India has also underperformed other large EMs for almost two years and is no longer a default overweight. The continued strong domestic flows, though they may weaken, also acts as a powerful offset to foreign capital outflows. However, towards the second half of the year, the uncertainty around elections will be front and centre. For India, investors continue to wait for broad-based earnings growth. In its absence, this market cannot go any higher. To deliver absolute performance, Indian corporate earnings have to finally deliver. 

The writer is with Amansa Capital