EMERGING MARKETS FACE FURTHER PRESSURE BEFORE THE ALL-CLEAR / THE FINANCIAL TIMES MARKETS INSIGHT

Emerging markets face further pressure before the all-clear

Forced sales and repeated pockets of illiquidity complicate matters for investors

Mohamed El-Erian




Move over Turkey. With a drop of more than 10 per cent last Thursday alone, Argentina displaced Turkey as the worst-performing (relatively widely traded) currency in emerging markets this year — and this for a county that seemingly had done all the right things to counter serious financial tensions.

Unlike Turkey, another EM under the spotlight, Argentina has adhered to the EM playbook for reacting and getting ahead of financial turmoil. But rather than reflect a negation of fundamentals, this highlights how technical and liquidity considerations are driving this market segment — a key issue for investors considering what to do and when.

Earlier this year, Argentina surprised many by announcing it was approaching the IMF to help counter mild pressures on its currency. The government sought to pre-empt further problems by tightening monetary and fiscal policies and securing front-loaded disbursements under a new $50bn programme with the fund.

Adding to the puzzle, last week’s steep drop in the peso came in the context of the central bank hiking interest rates by another 15 percentage points (to an eye-popping 60 per cent). President Macri indicated he was asking the IMF for additional support, and managing director Christine Lagarde signalled receptivity to reworking the programme with Argentina.

The peso, rather than stabilising, extended its losses to more than 50 per cent for the first eight months of 2018, a number approached only by Turkey among the relatively widely traded EM currencies — and a country [Turkey] that has been trying to rewrite the EM crisis management playbook by publicly ruling out the use of higher interest rates and IMF interactions.

This simple compare and contrast points to an important issue for EM investors.

While poor economic fundamentals, such as muted growth and excessive reliance on external debt, have played an important role in revealing vulnerable areas of EM as global financial conditions tightened and the US dollar appreciated, what we are now seeing is overwhelmingly a technical and liquidity phenomenon, including forced sales and repeated pockets of illiquidity.

The big question facing investors — whether they are looking to maintain, increase or reduce exposure — is the extent to which awful technicals and liquidity increases the pain for EM economies and asset prices, thereby sapping investor sentiment further.

You can already see this potential dynamic playing out in Argentina, which also faces an important presidential election next year. The sharp currency drop is aggravating the debt servicing burden for the private and public sector, undermining growth, discouraging new capital inflows and threatening large-scale capital flight. It also pressures domestic banks, further complicating what, for historical reasons, is already a fragile trust relationship with the IMF.

Meanwhile, judging from developments in credit default swaps, the currency disruptions have already translated in an excessive increase in the implied probability of a debt default. With that, last year’s heralded issue of 100-year bonds now trades at less than 70 cents on the dollar.

Given the plunge in asset prices and currencies, there is growing temptation to invest in the sector — and particularly so for diversified “carry trades” that could secure 60 per cent rates in nominal terms in Argentina (or around 30 per cent real rates for domestic investors), together with the potential for a currency rebound. Indeed a small addition of such exposure could turbocharge portfolios already heavily invested in investment grade and high-yield corporate bonds.

In considering such a strategy, investors should be willing to underwrite significant volatility risk associated with two factors.


First, partial market-based indicators suggest that sizeable amounts of “crossover” funds may still be trapped in what constitutes off-benchmark Argentine (and other EM) exposure that is subject to significant mark-to-market losses and higher reputational risk. They will probably take advantage of any favourable development in market liquidity/prices to get out. That means any rallies in prices may be shortlived, keeping several fundamentally driven long-term buyers on the sidelines until this phenomenon abates.

Second, the dismal performance of EM local currency funds (according to Morningstar, the average fund is down some 10 per cent so far this year, with even higher losses for some of the larger ones), will probably result in structural damage to this segment. Investors should expect the unfavourable effects of crossover outflows to be amplified by the exit of more dedicated investors.

These considerations are likely to apply in greater force to Turkey, where fundamentals are more of an issue. It also suggests that other less fragile EMs, such as Indonesia and Mexico, are not yet in the clear. It would not come as a great surprise if they were to experience in the next few months more waves of technical contagion and generalised selling by investors that also challenge the liquidity of their markets.

The good news about technical/liquidity EM disruptions is that, provided the general contamination to economic fundamentals is contained, they tend to fade. They offer investors the opportunity to gain exposure not just to extreme overshoots but also to other fundamentally stronger names selling at bargain-floor prices. But timing is critical, and especially for investors that lack the structural ability to underwrite significant market volatility. The current EM sell-off, while subject to temporary snapbacks, does not appear over yet.




Mohamed El-Erian is chief economic adviser to Allianz and author of the book ‘The Only Game in Town’