EM opportunity knocks — what to make of the recent market volatility

Emerging market debt has tumbled, but the macro story remains compelling

May 18, 2018 | Rashique Rahman, Sean Newman and Craig Altholz

Following two consecutive years of double-digit returns in 2016 and 2017, emerging market (EM) debt1 has had a rocky ride so far in 2018. However, in the view of Invesco Fixed Income, the proximate cause for the recent volatility has been a tightening in US financial conditions, not a deterioration in overall EM fundamentals. Therefore, we believe this EM correction has created the largest divergence between fundamentals and valuations seen in many years, and offers a compelling opportunity to add exposure to EM in local currency debt.

The US dollar has risen sharply

In February and March, a sharp rise in US dollar London Interbank Offered Rate (LIBOR), and in the spread between LIBOR and the Overnight Indexed Swap (OIS) rate, challenged valuations in core credit markets, triggering a cascading valuation adjustment across credit markets that included EM. EM local markets remained insulated as the US dollar remained weaker year-to-date. We are now seeing a rise in US real yields with the 10-year Treasury exceeding 3%,2 catalyzing a sharp rebound in the US dollar.

Figure 1: EM yields have recently risen along with US dollar LIBOR

US dollar LIBOR and JP Morgan Emerging Markets Bond Index Global Diversified (EMBI-GB) yield

The US dollar rebound has been particularly dramatic given what appear to be historically large speculative short positions that are in the process of being unwound. The complement to this unwind has been the selling of EM currencies. This has led to a marked depreciation of these currencies and an erasing of US dollar-based gains for the EM local debt index3 this year. EM credit has followed in sympathy, with yields and spreads widening. Only now are we seeing signs of the market recovering.

In particular, we have witnessed sharp depreciation in the Argentine peso (ARS) and Turkish lira (TRY) this month in the midst of the broader US dollar rebound. Both countries’ central banks have recently hiked rates in an effort to stabilize their currencies. Argentina had increased rates by a total 1,275 basis points through early May (to 40%) but currency depreciation continued, leading policymakers to approach the International Monetary Fund (IMF) for financial support.4 Meanwhile, the market is anticipating stronger action by Turkey to stabilize the lira as we approach the June 24 snap elections — yet to no avail at this point.

Why the EM volatility?

Argentina and Turkey are running large external deficits that require financing, and they are perceived by the market as the most vulnerable among EM based on their current account deficits and lack of sufficient reserves to cover their planned external funding needs. Both countries are reliant on external funding and, as such, the hint of tighter financial conditions (via a stronger US dollar) has exacerbated this sentiment. As a result, this has raised investor concern over these two countries in particular — as well as contagion implications for EM as a whole.

Broader market implications

What does this mean for the broader market? We believe that current EM country fundamentals suggest the moves in ARS and TRY should not lead to broader EM contagion — absent a sharp and sustained tightening in global financial conditions (which is not our base case). Overall, EM growth and macro momentum have continued to improve, so we do not view the market action in recent weeks as a sign of macro deterioration. Differentials between EM and developed market growth are an important driver of capital flows and EM debt returns, and we believe the improved EM cyclical growth dynamics may prove favorable for EM over the medium term in spite of the higher cost of US dollar funding. In addition, EM inflation has moderated to an extent not seen in recent memory, and balance of payments data have improved in aggregate.

Figure 2: EM growth momentum has improved over the past year

EM macro momentum versus JP Morgan Emerging Markets Bond Index Global Diversified spread

A compelling opportunity?

As a result, we believe the recent EM correction has created the largest divergence in underlying fundamentals relative to valuations seen in many years. In our view, this creates a compelling opportunity to add exposure to EM in local currency debt (where we see favorable return prospects in the coming years) and sovereign credit, given the recent improvement in underlying valuations.

Even in specific countries that have been punished for perceived policy mismanagement (such as Argentina and Turkey), we believe the market may be setting up for a decisive turnaround. Absent a persistently stronger dollar, the external vulnerabilities of these countries should not result in a liquidity event. Argentina is now on its way to making necessary macro-related adjustments to rebalance its economy under the auspices of an IMF program, and although deal risk is a factor that could lead to volatility in the coming weeks, so far authorities are providing assuring signals. We have not seen a resolute response yet in Turkey as the market also grapples with the post-electoral policy environment, but the re-pricing of risk in Turkish assets has been considerable.

Key takeaway

Recent developments remind the markets of the challenges faced by some economies in an environment of tighter US dollar funding conditions and how active management can play a role in navigating the trouble spots. For now, we do not see a sustained deterioration in global financial conditions given our view of contained core-market yields and the dollar. We believe this recent bout of volatility has opened up a compelling opportunity to add to EM exposure.

1 Source: J.P. Morgan Emerging Markets Bond Index Global Diversified
2 Source: US Department of the Treasury. Data from April 20, 2018, to May 14, 2018.
3 The EM local debt index is the JP Morgan Global Bond Index – Emerging Markets Global Diversified.
4 Source: The Central Bank of Argentina. Data from April 24, 2018, to May 14, 2018.

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