Emerging Markets Are Down Hard but Not yet OutBy
Local-currency bonds fall the most since 2008 financial crisis
Currency volatility and hedging costs show no sign of panic
The selloff in emerging markets after Donald Trump’s U.S. presidential election was intense. A closer look reveals that things aren’t as bad as they might seem.
While local-currency bonds suffered their biggest losses last week since 2008 following the Republican’s surprise victory, a gauge of volatility in developing-market currencies remained 16 percent below the levels seen in February. The cost to hedge against foreign-exchange losses is 38 percent cheaper than it was in August 2015 when China’s yuan devaluation rattled global investors.
In a global bond selloff fueled by expectations that Trump will increase government spending, emerging-market traders are by no means capitulating. While bracing for the risks of protectionist policies, they’re betting faster growth and narrowing current-account deficits will help most developing countries weather the rout.
The recent declines have “created a great buying opportunity,” said Koon Chow, a strategist at Union Bancaire Privee Ubp SA in London. “We could get to the stage where, in one or two weeks time, U.S. Treasury yields stabilize, and if that happens, emerging markets will come back.”
While it’s too early to call a bottom, Chow said domestic bonds in Brazil and Russia start to look attractive, together with the Colombian and Peruvian currencies. Asian exchange rates are likely to remain under pressure, he said.
More than $1.2 trillion was wiped off the value of global bonds last week as Trump’s win bolstered the view that a government spending splurge may accelerate U.S. growth and inflation. Emerging markets were among the hardest-hit as the real-estate mogul pledged on the campaign trail to pull America out of the Trans-Pacific Partnership, brand China a currency manipulator and build a wall along the border with Mexico.
Since the Nov. 8 election, developing-nation local-currency bonds have tumbled 7.3 percent through Nov. 11, the biggest three-day slump since October 2008. The decline cut the bonds’ return this year to 8.5 percent. Investors yanked a record $301 million from BlackRock Inc.’s $8.9 billion emerging-market fixed-income fund on Nov. 10. On Monday, U.S. 30-year yields rose to 3 percent for the first time since January.
In the currency market, Mexico’s peso plunged 12 percent to a record while the Brazilian real and South Africa’s rand have lost more than 7.8 percent each. On Monday, the Malaysian ringgit sank to a nine-month low and South Korea’s won depreciated to the weakest since June.
Still, there are indications that the selloff may be limited. While hedging costs in the currency market increased to a five-month high of 4.3 percent on Nov. 10, they were lower than those of 6.9 percent in August 2015, according to data compiled by JPMorgan Chase & Co. At 11.3 percent, JPMorgan’s gauge of currency volatility is below this year’s high of 13.4 percent set in February.
One reason is that emerging-market countries are on a stronger footing now compared with three years ago during the so-called taper tantrum when then Federal Reserve Chairman Ben Bernanke’s signal to reduce monetary stimulus sent a shock wave through global markets. Developing-nation local-currency bonds lost about 16 percent in less than four months.
Economic growth is picking up this year for the first time since 2010, with Brazil and Russia digging themselves out of recessions, the International Monetary Fund estimates. The average shortfall of current accounts in South Africa, Brazil, Turkey, India and Indonesia, a group branded as the “fragile five” by Morgan Stanley in 2013, has shrunk to 2.4 percent of gross domestic product, from a record 5 percent in 2013, according to data compiled by Bloomberg. Foreign reserves have increased in countries including Indonesia and India, providing them with ammunition to defend their currencies.
“Fundamentals are much stronger than going into the taper tantrum.” said Paul McNamara, a money manager at GAM UK Ltd. The selloff “just strikes me as a little bit extreme,” he said.
Strategists at Morgan Stanley and Citigroup Inc. warn that the rout is likely to deepen. Trump’s protectionist overtures, if acted upon, would slow exports from and reduce investments to developing markets, they say.
In addition, central banks in the U.S., Europe and Japan are either ready to raise borrowing costs or stop easing further, dragging Treasuries yields up and putting pressure on emerging markets, Citigroup’s analyst Dirk Willer wrote in a note Friday. Local debt in Mexico, Poland and Hungary are most vulnerable to rising U.S. yields, he said.
Analysts at Morgan Stanley estimate that investors are overweighting domestic bonds and have hedged between about 10 percent and 30 percent of their currency exposure in Brazil, Indonesia, Russia and South Africa. If the selloff extends, investors may have to cut their holdings and increase their purchases of insurance, exacerbating the decline.
For now, McNamara said he’s willing to give Trump the benefit of the doubt. He’s looking to buy the South African rand once there’s some clarity about the direction of the new U.S. government.
“We just sit tight at the moment,” said McNamara, whose Julius Baer Local Emerging Bond Fund returned 13 percent this year. “All the negative is based on various assumptions. We’ve got very little hard evidence in terms of what the new administration is going to mean for emerging markets.”