China and Dollar Test Emerging Markets’ Bull Run

Factors supporting the market no longer look so solid; rising U.S. Treasury yields and a stronger dollar pose risks

By Richard Barley



OFF THE BOIL
Total return on emerging-market and developed-market stocks, in dollar terms


Source: FactSet



Good times can’t last forever. Last year, strong global growth and a weak dollar lit up emerging-market stock and bond returns. But the low-hanging fruit has been harvested. And now times are looking tough.

After a strong start to 2018, emerging-market stocks have suffered, and the stronger dollar has hit bond returns. The JP Morgan GBI-EM local-currency bond index now up only 1.8%, versus 5% in January.

Factors supporting the market no longer look so solid. China’s unexpected cut in bank reserve ratios raises questions about whether the emerging world’s most important growth engine has hidden weaknesses. Capital Economics’ emerging growth tracker slowed to 4.4% in February from 4.6% at the end of 2017. The upgrade to global growth in the latest International Monetary Fund forecasts was down to higher forecasts for advanced economies, reducing the allure of higher growth in emerging nations.

Meanwhile, rising U.S. Treasury yields and a stronger dollar pose risks. The ICE U.S. dollar index has risen 3.4% from its February low. Riskier high-yielding emerging-market currencies like the Brazilian real, Turkish lira and South African rand have fallen this year, and even low-yielding countries with better fundamentals have seen some reversal recently, notes BNP Paribas . That removes a tailwind that propelled emerging-market assets last year.
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After a strong start to 2018, emerging-market stocks have suffered, and the stronger dollar has hit bond returns.
After a strong start to 2018, emerging-market stocks have suffered, and the stronger dollar has hit bond returns. Photo: Reuters
 

Political risk is on the radar. Trade clashes between the U.S. and China raise questions about the process of globalization that has lifted growth in emerging markets; geopolitical tensions leading to sanctions on Russia have slammed the ruble. Elections are due in some important emerging nations, including Brazil, Mexico and Turkey, which make investors nervy.

If the world economy is only going through a soft patch, then the potential returns afforded by some emerging-market assets, bonds especially, still look attractive. Emerging-market bonds offer higher yields than available elsewhere: the yield on the GBI-EM index is over 6%.


DOLLAR DAMPER
Currencies of high-yielding emerging countries have diverged from those of low-yielding countries against the dollar

 
Source: FactSet
Note: High-yielders are Brazil, Indonesia, Mexico, Russia, South Africa, Turkey; Low-yielders are China, Malaysia, Singapore, South Korea, Taiwan, Thailand




Still, emerging-market investors have invested a lot of faith in the idea that many countries used recent leaner years to fix some of their problems, reducing current-account deficits and making themselves less vulnerable.

That theory still makes sense. But with conditions less hospitable, it faces a bigger test. Expect more divergence among countries. A rougher patch lies ahead for emerging markets.

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