Spring is in the air throughout the northern hemisphere, but the first full week of May saw a chill descend on emerging markets.
A stronger dollar, boosted by expectations of rising interest rates in the US, has dented demand for emerging market equities and bonds. Political turmoil in Malaysia, an Argentinian currency crisis requiring IMF intervention and uncertainty over US trade with Mexico and China have added to the list of headwinds for emerging markets.
The recent turmoil has even been compared to the 2013 ‘taper tantrum’, when the mere mention of a slowdown in asset purchases by the US Federal Reserve sent shockwaves through the global financial system.
Do the more recent market events simply amount to a short-term correction or have they dealt real structural damage to the popular emerging markets story? Investors seem convinced of the latter.
According to the Institute of International Finance (IIF), since mid-April 2017 total outflows from emerging market debt and equity markets combined have amounted to $5.6bn (£4.16bn), split equally between the two asset classes. The JPM Emerging Markets Currency Index also fell 6 per cent between the end of February and early May.
Firstly, it is important to realise that the recent turmoil has not had the same impact, at least in terms of returns, as the taper tantrum. The graph below shows maximum drawdowns in emerging market bond and equity markets. Both markets lost more than 12 per cent five years ago, while they have lost just slightly more than 7 per cent this year. Therefore, emerging market equities and credit still have a long way to go if history is to repeat itself.
This sounds reasonable given that emerging market governments have stronger buffers against default than they did in 2013, which has helped stabilise sovereign debt markets. The current account balances of the so-called Fragile Five (Turkey, South Africa, Indonesia, Brazil and India) are in much better shape.
Brazil, India and South Africa have managed to significantly reduce their current account deficits over the past five years. Thailand, another dollar-exposed emerging market country, has turned its shortfall into a surplus of more than 10 per cent of gross domestic product. This helps reduce their reliance on foreign investment to balance their books.
Emerging markets have further reduced their dependence on US dollars by issuing debt in local currencies. Governments have increasingly tapped into domestic capital markets, and having a domestic buyer base means that these markets have become less vulnerable to the whims of global capital flows.
Finally, the political situation has improved. Indian Prime Minister Narendra Modi’s pro-business reforms and the new South African President Cyril Ramaphosa’s anti-corruption agenda should boost investment opportunities in these markets. More recently, the Argentinian government has not hesitated to call on the IMF for help in stemming the peso’s decline against the dollar, in a move that harks back to a dark time for the country.