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Investors are fretting over a rocky few weeks for emerging markets, with some worrying of a replay of the ‘taper tantrum’ that knocked markets in developing economies in 2013.
Emerging market stocks, bonds and currencies have had a glum month as the dollar has rallied, rising 3.7% against a global basket of currencies and wiping out its losses for the year.
A stronger dollar is seen as a threat to emerging markets as it makes their dollar debts more expensive. This was seen in the ‘taper tantrum’ of 2013, when the US Federal Reserve sparked a sell-off in markets after announcing it would start reducing the amount of bonds under its quantitative easing programme. Emerging markets were the worst hit as the dollar continued to climb.
‘It’s been a turbulent couple of weeks for emerging markets, with stocks, bonds and currencies all taking a battering,’ said Brett Diment, head of emerging market debt at Aberdeen Standard Investments.
‘After a stellar run for emerging market debt in 2017, the spread over US treasuries is back to where it was two years ago, prompting comparisons with the “taper tantrum” of 2013.’
No country has been worst hit than Argentina, where the dollar’s strength has combined with the country’s efforts to support its weakening currency to create a perfect storm.
The Argentinian currency has lost nearly a quarter of its value against the dollar over the last three weeks, falling to an all-time low as the country struggles to deal with rampant inflation.
With prices rising by more than 20%, Argentina’s central bank was forced to raise interest rates to a whopping 40%. The government has now gone cap-in-hand to the International Monetary Fund for help.
Jan Dehn (pictured), head of research at emerging markets specialist fund group Ashmore, said Argentina’s problems were ‘entirely self-inflicted’.
‘The underlying reason for the failure to control inflation lies with the fiscal authorities. They have consistently insisted on lavish spending to avoid a recession during the monetary adjustment period.
‘However, the resulting combination of high fiscal spending and high real interest rates attracted a lot of hot money (which is now leaving head over heels), but failed to stimulate real investment since the large volumes of government debt issuance crowded out the private sector.’
David Roberts, head of global fixed income at fund group Liontrust, said the news reinforced his bearishness on broader emerging market debt.
‘For all those who have recently piled into emerging market debt, it is a salutary reminder of the risks involved in what remains a very expensive market,’ he said.
‘Returns on emerging market bonds are still dominated by capital flows in my opinion and if the IMF rides to the rescue in Argentina, it may be too late to stem another period of outflows from the asset class.’
Argentina’s woes will be a worry to the bond fund managers who have built up heavy exposure to the country. While Argentinian debt has suffered in recent weeks, it has been spared the full-throttle sell-off of its currency. A lot of emerging market debt is insulated from some of this foreign exchange risk as it is priced in dollars, but some investors fear the country’s currency problems could spread to its debt.
Among the bond investors with large exposure to the country are Steven Hay, Sally Greig (pictured) and Yannis Lykouris, who hold 12.8% of their £914 million Baillie Gifford Emerging Markets Bond fund, the largest single country exposure.
Greig said they had trimmed some of the fund's Argentina exposure, and that the portfolio had been spared some of the currency sell-off as a lot of their exposure was US dollar debt. Any local currency debt was meanwhile very 'short duration', having limited vulnerability to interest rate rises. The fund's second largest holding, debt issued by Buenos Aires, is a floating rate note, meaning its coupon rises as interest rates rise.
The trio have held Argentinian debt since 2016, buying into the country on the prospects of better economic management and reforms. Greig welcomed the government's swift response to the crisis, saying it 'underlined the commitment to better governance'.
'The fortunes were never going to unfold in a straight line,' she said. 'Crisis is often a great opportunity to expedite those positive measures you want to see.'
Among others with significant exposure to Argentina are Omar Saeed, who holds 8.5% of his £404 million Legal & General Dynamic Bond fund in the country’s debt, while the £104 million Aberdeen Emerging Markets Bond fund holds 7% and Kieran Curtis and Mark Baker hold 6.7% of their £112 million Standard Life Investments Emerging Markets Debt fund in the country’s bonds.
Diment meanwhile hasn’t been cowed by Argentina’s problems. ‘The government has been moving in the right direction, liberalising the exchange rate and freeing up utility prices,’ he said.
‘In the short term, this has driven up inflation. But there’s already been progress in reducing the fiscal deficit.
‘We are also positive on the country’s application to the IMF for aid. And Argentina’s foreign reserves are much higher than in the past.’
He dismissed fears over contagion from the currency markets to the bond markets. ‘Large foreign-exchange devaluations have not been a major factor in emerging market debt’s historical performance because only a small portion of the emerging market corporate debt universe is exposed to foreign exchange risk,’ he said.
‘This is one reason why, for instance, the Argentinian peso fell by 183% between 2014 and 2017, yet Argentinian corporate credit delivered a positive return of 44%.’
‘The goal in this case, for both sides, would be to ensure stability so that Argentina does not return to its failed populist policies under a new administration,’ she said.
‘The current government is full of technocrats that understand this and, if push comes to shove, would convince [president Mauricio] Macri that this is his least worst option.’
Dehn meanwhile argued that Argentina’s problems should not spill over into broader emerging markets.
‘Of all the 79 investable countries in emerging markets, only the Argentinians believe that nearly two decades of excess demand stimulus can be reversed without fiscal adjustment,’ he said.
‘To the extent that herd-like behaviour and meaningless extrapolation of the experiences of Argentina… to the rest of emerging markets leads weaker hands to capitulate on their emerging markets positions with the result that currencies move lower and yields move higher, this is clearly something that stronger, wiser investors should aim to exploit.’
Dehn argued the pressure placed on emerging markets by the rallying dollar was likely to abate. ‘It is abundantly clear to us that the bounce in the dollar is not sustainable,’ he said.
‘First, investors are already very long dollar assets. Second, the US economy is running at full employment and accommodation is being withdrawn, so the growth outlook is uncertain to negative.’
But Fidelity fund manager Paul Greer was more bearish, warning that the dollar could continue its march higher.
‘We feel the dollar has crossed the Rubicon in recent weeks and is now set for further gains,’ he said.
‘Our asset class never trades well when the greenback is strengthening and recent price action illustrates how quickly sentiment can turn.
‘Argentina’s experience over the past two weeks acts as a cautionary tale for EM investors positioned in overpopulated markets with vulnerable fundamentals. Given our expectations of further US dollar appreciation in the near-term, we don’t think it will be the last.’