Four potential events this year could lead to an emerging markets pricing snapback
Certain emerging markets are more vulnerable than others to a major repricing of risk premia
Continued ‘Goldilocks’ economic conditions and the hunt for yield are valid reasons why emerging market (EM) investors can view the glass as half full, but there are also good reasons for increased caution and February’s market wobble may well be a warning shot across the bow. We see four key triggers that could lead to a snapback for EM.
1. A US bond market selloff
This year, the 10 year US Treasury bond yield has risen sharply on a firming US inflation outlook, a deteriorating US fiscal outlook and the Fed winding down quantitative easing (QE). Sharply higher US bond yields (the benchmark for the pricing of all global assets) could trigger a reappraisal of the investment risk-reward in global credit markets, sparking a major decompression of EM credit risk premia. If sharply higher US bond yields are accompanied by US dollar (USD) appreciation, the repricing of EM assets could be further amplified.
But here’s what makes it more ominous: the continued huge investor appetite for EM bonds despite worsening credit quality and declining compensation for credit risk. EM high-yield corporate bond issuance surged to a record high in 2017, and yet EM credit spreads remain compressed near multi-decade lows. The Institute of International Finance has spotted a growing disconnect between declining EM sovereign credit ratings and rising investor bond allocations to EM. Of course, there is a logical explanation for this (global QE) to which we turn next.
2. The global QE unwind
Just as QE was successful in pushing global investors into riskier, higher-yielding EM assets, the unwinding of QE will have the opposite effect, but potentially in a more non-linear fashion because of the large build-up of EM debt, complacency created by the unusually long period of very low interest rates and the speed at which market liquidity can evaporate. Currently, on a global scale, the Fed’s quantitative tightening (QT) is being more than offset by ongoing QE by the European Central Bank (ECB) and Bank of Japan (BOJ), which has stopped QE but has yet to move to QT. Assuming the ECB ceases its asset purchases in September, the BOJ continues buying Japanese government bonds at a de facto annualised rate of ~JPY45trn and the BOE continues to hold its balance sheet constant, aggregate G4 central bank QE will turn to QT in Q4 2018.
3. A China growth slowdown
In the past year, China’s economy has been a bastion of stability, and “China risk” has faded from the radar screen, however there are two reasons why we could see a slowdown in the near future.
Firstly, the unrelenting crackdown on shadow financing, market speculation, corruption and pollution represents an increasing drag on growth. Even though the benchmark 1 year lending rate is unchanged, banks have raised their commercial lending rates, and growth in the broadest measure of credit (aggregate financing) has slowed.
Secondly, the surge in producer price inflation last year that boosted the profits of struggling upstream State-Owned Enterprises (SOE) is fading. EM is more exposed than developed markets (DM) to a China growth slowdown, both directly through exports and indirectly through declining commodity prices.
4. Risk of a trade war
This year, the Trump administration has taken a more aggressive stance on trade. The outcome of the Section 301 investigation, the ballooning US trade deficit with China (to a record high of USD380bn) and US midterm elections in November heightens the risk of growing tit-for-tat trade protectionism between the US and China that, in the worst case, could flare up into a full-blown trade war. After decades of trade liberalisation that has driven the fragmentation of production across countries (a full one-third of the value-added in China’s exports is sourced from other countries), growing trade restrictions by the world’s two largest economies is bound to hurt exports of other countries. Here again, EM is more exposed than DM: of the world’s major economies, seven out of 10 of the most open to trade are in EM.
Timing the snapback in EM
There are four reasons that suggest Q3 2018 seems to be the most high-risk quarter for an EM snapback. First, it is most likely to be the last quarter before G4 aggregate central bank assets start to shrink outright, and we would expect markets to react ahead of time. Second, it will be around the time that President Trump will need to shore up his core support base ahead of midterm elections in November by following through on some of his campaign pledges, notably pushing harder on the trade protectionism button. Third, by Q3, several new members of the FOMC will have settled in and a continued diminishing of economic slack could start to tilt US monetary policy towards a more hawkish bias. Finally, as China growth slows, it could be around Q3 that we see some dead wood in the corporate sector rise to the surface.