The battle between risks and fundamentals

In a nutshell

• The global environment is not conducive for emerging markets to thrive, but the countries most affected to date have been those with the weakest fundamentals or highest political risk.
• Absent a scenario of continued strong dollar appreciation or material trade war, the emerging complex does not pose systemic risk.
• A cautious and selective approach thus remains warranted.

Emerging economies are facing a growing number of headwinds, including rising US yields, a stronger dollar, trade war threats, and domestic political risks. While the overall trade-weighted exchange rate is down only 1.7% since the beginning of the year, some emerging currencies have undergone substantial pressure. Unsurprisingly, they belong to the countries with the weakest fundamentals or highest political risks: Argentina (-30%), Turkey (-15%), Brazil (-9%), South Africa (-8%), Russia (-6%) and Hungary (-6%). The sell-off has been lesser for other emerging countries, with countries like Thailand, China, Peru, Malaysia, Colombia, and even Mexico, posting appreciation over the 1st half of 2018 (see chart X).

As such, emerging markets do not appear to pose systemic risk. Rather, the issues seem idiosyncratic and are starting to be tackled: Argentina got a stand-by agreement from the International Monetary Fund (IMF) and Turkey has raised rates quite markedly.

Clearly, in a scenario of continued and substantial greenback appreciation, emerging economies would find it difficult to escape the vicious circle of capital outflows, currency weakness, tighter policies and slower growth. Similarly, a material trade war between China and the US would have very tangible negative consequences for the emerging complex.

But assuming the dollar stabilises, perhaps even weakens slightly, and trade tensions de-escalate, emerging markets fundamentals are by no means as worrisome as recent market action and sentiment would suggest.

Non-financial corporate debt build-up peaked in 2016 and has stabilised since. External debt and budget deficits could admittedly afford some improvement but are at manageable levels for two thirds of the 18 largest emerging countries. Current account deficits have subsided, greatly reducing vulnerability to external financing. And the emerging recovery is still young, dating back only 3-4 years versus nearly 10 in the US. Few inflationary pressures are thus apparent, and interest rates remain at very low levels – leaving central banks room to defend their currencies.

So, while there is no denying the difficult global backdrop, which will keep volatility high, emerging markets also offer economic and financial value to cautious and selective investors.