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Emerging Market Debt: Reasons For Confidence Tempered With Caution

With rising US interest rates and the US-China trade war intensifying, 2018 was a volatile year for emerging markets (EM). The US dollar’s strength led to broad-based EM currency depreciation, aggravated by currency crises in Turkey and Argentina. In this article we examine the prospects for EM debt in 2019.

Letters between Beijing and Washington

Examining fundamentals, there are reasons for optimism. A few countries aside, debt is not at levels that would present systematic risks. Furthermore, the superior growth rates of EM countries provide a tailwind for the asset class; while growth is likely to remain soft at first, the differential over developed markets should increase as the year progresses. As a result, capital flows into EM should improve.

The US growth cycle is also important. We expect US growth to moderate but avoid a recession; this would prompt the Federal Reserve (FED) to conclude its rate-hiking cycle, relieving the pressure on EM currencies. However, continued economic strength in the US that results in a hawkish Fed would be an adverse scenario for emerging markets, as currencies again would be expected to depreciate against the dollar. The result of the US mid-terms, which should reduce the chance of further fiscal stimulus, offers grounds for optimism here.

Another potential catalyst is China. In addition to US tariffs taking effect, China’s economy is slowing; GDP growth for the third quarter of 2018 was the lowest since 2009. But Beijing has considerable monetary and fiscal firepower at its disposal (Chart 1). Efforts are already being made to improve corporate access to credit, and issuance of municipal bonds to fund infrastructure investments has been rising. Should these measures prove insufficient, we can expect further monetary easing, more local-government bond issuance and, potentially, a cut in corporate taxes. The positive impact on EM debt markets is likely to be smaller than the massive infrastructure-related stimulus measures of 2009 and 2015/16, but it could still be considerable.

Against these positives, there are certainly risks. The most obvious danger is an intensification of the US-China trade war. The temporary ceasefire agreed at the G20 summit in Argentina already looks fragile, and the most likely scenario is that US protectionism will persist, jeopardising global trade. China will remain the focus, although global tariffs on cars represent an additional risk.

But given the unpredictability of the US administration, there’s also a possibility that the trade war might end sooner than most expect. Any resolution of the conflict would significantly boost sentiment towards emerging markets – especially as an escalation of hostilities is already priced in.

Elections on the horizon

Politics also presents risks, although these are likely to be more country-specific than the consequences from 2018’s elections in Mexico and Brazil. In Argentina, President Macri is currently level in opinion polls with populist former president Kirchner. Macri’s hope is that the economy will recover in time for October’s election, but this might be overly optimistic. If Kirchner wins, her previous statements make it difficult for the markets to imagine her cooperating with the International Monetary Fund (IMF) on the reforms that the country so urgently needs.

In South Africa, the ruling African National Congress is certain to retain its parliamentary majority, but the margin of victory might change the balance of power between President Ramaphosa and his party rivals. The country’s credit rating has been on a downward trajectory over the past few years, and decisive policy action is needed to change that. This can only be achieved under an empowered president. Meanwhile, India’s ruling party has been pressing ahead with much-needed reforms, but further progress depends on it retaining its position in the 2019 general elections. Recent defeats in state elections suggest that this is far from certain.

However, the rising cost of such investment, sometimes for poor returns, means that Beijing is moving to withdraw subsidies for manufacturers and developers to reduce the burden on the state. It means the industry will need to adopt technological innovation and economies of scale to improve efficiencies, while also looking to the private sector for support.

Ukraine, however, is a special case. Its debt sustainability remains questionable, but the country has been in an IMF programme that has helped it to implement important structural reforms and regain market access. However, March’s presidential election could imperil this. Former Prime Minister Tymoshenko currently has a significant lead in the polls on a populist programme. Given rising tensions with Russia, Ukraine also represents a potential geopolitical flashpoint.

Oil effects

Finally, there’s oil. Despite recent weakness, the oil price is still higher than the assumptions baked into most EM budgets. But a weaker oil price is likely to benefit local-currency debt markets rather than hard-currency ones. That’s because oil importers – including India and many other Asian countries – make up a higher proportion of local-currency benchmarks than oil exporters, who have a greater share of the hard-currency indices. As such, there are opportunities as well as risks here.

Overall, 2019’s risks appear largely country-specific. The potential catalysts for positive performance, however, are broader-based, and the systematic risks – such as a step-up in the US-China trade war – are already priced in. So, we enter 2019 with some confidence, albeit tempered with caution.

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