The Outlook: August
2018 economic commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges.

Emerging Markets Under Pressure From Rising Dollar and Trump Policies

“It’s only when the tide goes out that you learn who has been swimming naked.”

The billionaire investor Warren Buffet’s famous quote has been applied to a variety of situations, but seems particularly apt at the current juncture, with the ‘tide’ in this case taking the form of US dollar liquidity.

The US dollar plays a key role in determining global financial conditions. This is in large part because most external borrowing by non-US corporations, either in the form of bank loans or bonds, is denominated in US dollars. Borrowing in US dollars is particularly prevalent in emerging markets (EM), with outstanding EM corporate debt issued in US dollars more than tripling since the financial crisis to over $1 trillion. As the dollar appreciates, a company has to pay back more in local currency to service its US dollar-denominated debt. In turn, such companies could find it more difficult to borrow, with adverse implications for employment, investment and ultimately GDP growth.

Against this backdrop, it is no surprise that the strengthening of the US dollar that has occurred in 2018 as US growth has outshone the rest of the world, has soured sentiment towards emerging market economies. Emerging market assets have performed poorly in 2018 and currencies have weakened, generally led by those economies with large external deficits.

Trump compounds emerging market woes

Emerging market economies have traditionally been vulnerable during periods of rising US interest rates and US dollar appreciation. However, recently pressures have been compounded by the policies of the Trump administration, which has been willing to use trade policy and sanctions to pursue political objectives. In recent months, the escalation in the US-China trade conflict has accentuated worries over a slowing economy and contributed to a sharp fall in Chinese equity markets. More generally, protectionist US policies threaten to undermine emerging market economies, that have benefited disproportionately from globalisation. Meanwhile, recent US sanctions on both Iran and Russia have seen their respective currencies fall sharply.

Turkey has been hit on both fronts. The trigger for the latest lurch down in the Turkish Lira to a record low (see chart below) was President Trump’s decision earlier this month tdouble tariffs on Turkish steel and aluminium, and to sanction two Turkish cabinet ministers following Ankara’s detention of a US pastor on terror-related charges.

Turkish Lira to US$ chart

However, the Turkish currency had been under pressure for long before this as a result of a strengthening US dollar, a large current account deficit (5.5% of GDP in 2017) and high levels of foreign debt. Moreover, a deterioration in the external environment had exposed shortcomings in domestic macroeconomic policy. The Turkish central bank, under pressure from President Recep Tayyip Erdogan to keep interest rates low, has failed to respond to an overheating economy, which grew 7.4% in 2017 – the fastest in the G20. As a result, inflation is currently running at nearly 16% – more than three times the central bank’s 5% inflation target. President Erdogan’s appointment of his son-in-law as finance minister in July further undermined investor confidence in the credibility of economic policy.

The fallout from Turkey

Investors are obviously concerned about the potential for the crisis in Turkey to negatively impact the global economy and financial markets. The direct hit should not be large. Turkish GDP represents around 1.5% of global GDP, and the country makes up less than 1% of the MSCI Emerging Markets equity index. The country’s share in emerging market bond indices is bigger, typically around 6%.

Amidst growing concerns that a plunging currency will result in rising defaults on external liabilities, there have been heightened fears over the exposure of European banks. Analysts at JP Morgan calculate that Spanish and Italian banks are most vulnerable in this regard - with total balance sheet exposure to Turkey of 4.5% and 2.1% respectively – but conclude that, with banks having strengthened their financial position in recent years, they are well placed to handle any fallout.

The escalation of the Turkish crisis has ushered in a period of risk aversion on the part of investors, but there are good reasons to suggest that recent developments will not usher in a broader EM or global crisis. Emerging markets experts have been at pains to stress that Turkey is not representative of the broader EM universe. Most notably, President Erdogan’s unconventional view that raising interest rates causes inflation stands in marked contrast to the orthodox, inflation-targeting monetary regimes now prevalent in most developing countries.

Improved current account positions, floating exchange rates and a more effective regulatory environment suggest that EM economies in general are less vulnerable to external financing shocks than they were prior to the EM crises of the late 1990s. Admittedly, there has been a marked increase in debt in many EM countries in recent years, most notably in China. However, the development of local bond markets in many economies has constrained the rise in external financing, mitigating some of the risks associated with a stronger US dollar.

Even so, recent developments are likely to keep investors on edge. Withdrawal of monetary stimulus in developed markets, the US-China trade conflict and the risk of further US sanctions represent significant headwinds.

However, more balanced global growth later in the year could ease pressure on EM economies. The 4.1% annualised gain in US GDP during the second quarter is unlikely to be sustained, and the economy is likely to slow somewhat going forward. In contrast, recent stimulus measures in China should underpin activity in the world’s second largest economy. A narrowing growth differential between the US and the rest of the world could in turn take some steam out of the US dollar rally that has hampered emerging markets this year.

Don’t throw the baby out with the bathwater

All of this suggests that recent developments should not be a trigger to exit emerging market assets en masse. The current period of generalised risk-off sentiment holds out the prospect of throwing up long-term opportunities for selective investors. Valuations in both EM bonds and equities are favourable versus developed markets, and long-term structural drivers, such as a growing middle class, remain in place. While heightened geopolitical risks and a maturing economic cycle argue for a cautious approach, emerging market assets still have a place in a diversified portfolio for longer-term investors.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.