Catch-Up Potential For EM Currencies
Summary
- As the Emerging Markets Debt team gathered at the recent World Bank/IMF annual meetings, the mood was cautious but much improved from 12 months ago.
- The team anticipates growth improvements across all emerging regions, and among both frontier and advanced countries, in 2020.
- While hard currency spreads could tighten further, local currency bonds are more likely to outperform in an environment of improving growth and rising yields.
- Local currency yields are low, however, and so the focus is on emerging markets foreign exchange (FX), where valuations remain attractive.
As growth bottoms out and tail risks ease, attractive valuations support the case for emerging markets currencies.
This edition of CIO Weekly Perspectives comes from guest contributors Rob Drijkoningen and Vera Kartseva of Neuberger Berman’s Emerging Markets Debt team.
In mid-October, the Neuberger Berman Emerging Markets Debt team held its off-site gathering in Washington, D.C., on the heels of the annual meetings of the Board of Governors of the World Bank Group and the International Monetary Fund.
The general feel from World Bank/IMF sessions was one of caution but not great anxiety. Supply chains and capex plans have adjusted as everyone braces for the impact of the global growth slowdown and trade tensions. Central banks and consumers could cushion the downside and help avoid a near-term recession in the U.S. These dynamics were reflected in the IMF’s growth forecasts, which saw downgrades across the board for 2019, but modest upside potential for next year.
Modest Upside Potential for Emerging Markets Growth
Our own outlook, based on a GDP-weighted aggregation of 80 detailed, country-by-country forecasts, is for growth in emerging markets ex-China to increase from 2.8% to 3.2% next year. We anticipate improvement across a wide set of countries in all regions, including both frontier and more advanced economies.
Among larger economies, we believe growth in Brazil will increase from 0.9% to 2.0%, in Mexico from 0.5% to 1.3%, in Russia from 1.4% to 1.9%, in Turkey from -0.1% to 2.1%, in South Africa from 0.7% to 1.3% and in India from 6.5% to 6.6%. Countries in Central and Eastern Europe are likely to see growth decline from today’s relatively elevated levels, due to delayed effects from the slowdown in Germany—but even here, strong local consumption has made economies strikingly resilient.
Encouraging
Along with these improved individual country outlooks, we also note some bottoming out in factors that contributed to the recent growth slowdown, such as the lagged effects of monetary policy tightening in U.S. and China, and the dwindling of inventories built up because of earlier, unrealized strong growth expectations.
It was encouraging to see new orders increasing and finished goods inventories declining in the JPMorgan Global Manufacturing Purchasing Managers’ Index (PMI) for October, as well as a substantial de-escalation in the U.S.-China trade war, which will likely improve the outlook and raise confidence.
Central banks are doing their part. Global monetary policy is now arguably as accommodating as at any point since the financial crisis. In February of this year, we were looking at nine months of hikes and no cuts by the world’s 37 central banks. Today, around 15 could cut rates and almost none are set to hike.
Given historical patterns, this easing of financial conditions should soon start to show up in macroeconomic data—we may already be seeing it in the better-than-expected third-quarter GDP data out of Europe and Global Manufacturing PMI. In Asia—which slowed down first and should therefore be expected to lead the recovery—industrial production improved in China, Korea and Japan in September, while October PMIs suggest a stronger fourth quarter.
The Case for Emerging Markets FX
A modest upturn in global growth would strengthen the case for local currency versus hard currency emerging markets debt.
While we still think hard currency spreads are likely to tighten, especially among higher yielders, its seven-year duration usually causes underperformance relative to local currency bonds when growth and yields are rising. Having said that, local bond markets are somewhat crowded and yields there are at historically low levels, which complicates the case for local currency duration. We therefore favor emerging markets foreign exchange exposure and duration only in higher-yielding countries.
Except for a brief respite in 2017, emerging markets currencies have been out of favor since 2013. Investors’ positioning in emerging markets FX is low compared with other asset classes. Fundamental exchange rate models, which take into account metrics such as current account and terms of trade, now suggest that the majority are trading cheaply. Improvements in country fundamentals, such as reforms in Brazil or restrained fiscal and monetary policies in Russia, have also helped to improve valuations.
Recent developments do not mean growth is certain to improve. Among other things, we are closely watching whether the consumer can keep the U.S. away from recession, and an unexpected re-escalation of the trade war would definitely further dent weak global business sentiment.
With the modest rebound in growth under our central scenario, however, we are now moving to a more positive stance on emerging markets FX alongside our existing overweight in emerging markets credit.
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