NN IP: Emerging market assets are coming under pressure

A positioning squeeze in emerging market debt (EMD), triggered by the combination of rising oil, steady Fed re-pricing and a strengthening dollar, has led to a 80-bps EM spread widening and a 7% EM currency depreciation since the beginning of February. Most selling pressure has materialised in the past two weeks, when the US dollar appreciated sharply.

The stronger dollar, coupled with the steady rise in the oil price, justifies a more critical look at the EM inflation picture. Benign inflation, moving in a tight range of 3%-4% in the past four years, was the primary factor that helped boost investor risk appetite for EM. Strong inflows strengthened EM currencies and enabled central banks to meet inflation targets while reducing interest rates.

This virtuous cycle lasted for years, but has been interrupted in the past months, first by the sharp oil price increase and later by the appreciating dollar. Higher oil prices lead to higher energy costs, or to larger fiscal deficits if fuel subsidies are in place. Higher oil prices also have a second-round effect on food prices, which in EM represent a relatively large weight in the CPI basket. This is why substantial oil price rises normally have a big impact on EM inflation expectations. The appreciating dollar of the past weeks has made this impact even larger, as a stronger dollar increases the local-currency costs of energy and other imports even more.

So the deteriorating EM inflation outlook explains most of the recent selling pressure on EMD. Whether the pressure will intensify or soften will depend on the oil and the dollar. With EM growth dynamics of the past years having been positive but never excessively so, we do not see a good endogenous justification for worsening EM inflation. But as long as the global environment stays as it is, with rising oil, steady Fed re-pricing and an appreciating dollar, outflows from EMD are likely to continue.

This introduction about inflation and EMD helps explain the recent moves in EM equity markets. Since their 22 March peak, EM equities underperformed developed markets by 6 percentage points. This is substantial, but not enough to break the positive trend that started more than two years ago (see Figure 1).

EM equities are feeling the deteriorating EM inflation outlook and the position unwinding in EMD that is leading to depreciating currencies and rising yields. The effects are direct, through currency weakness that pushes the dollar value of the category down, as well as indirect, through higher discount rates and an adjustment in growth expectations. The main reasons why the EM equity correction has been modest so far are the positive economic and earnings growth momentum and the resilience of China, India, Korea and Russia, which together represent more than half of the EM universe. 

Tighter financial conditions pose a risk to EM growth

Thanks to the steady recovery in EM credit growth, from 6% in Q1 2017 to 10% now, that is pushing domestic EM demand growth higher, and the still-strong global demand that has kept EM export growth in double digits, EM growth continues to be in its tight 4.5%-5.5% range. With Chinese growth gradually slowing, this implies that EM growth momentum ex-China is positive.

So while the global environment for EM has become more challenging, the starting point of EM growth remains positive. A turnaround would require a large and lengthy tightening of financial conditions. Figure 2 shows our own EM financial conditions indicator, which captures changes in policy rates, interest rate expectations, fiscal policy, exchange rates and foreign capital flows for the whole EM universe. This indicator was positive for most of the past two years. Since April it has come down and last week it turned negative. A continuous deterioration could stop the credit growth recovery in EM with negative implications for future consumption and fixed investment growth throughout the emerging world. For now, we feel it is too early to call the end of the EM credit recovery.

Meanwhile, the relative strength of China, India, Korea and Russia in this environment is encouraging. These markets should help to keep the EM-DM outperformance trend intact.