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Emerging Markets in Search of a Fresh Impetus

Jul 20, 2020

• EM equities and bonds have stalled in recent days
• Recovery prospects for some EMs have been dimmed by poor virus response
• Sharp trade reversals have been in evidence, but a slow recovery is now underway
• Debt accumulation is inevitable; further creditor support may be necessary
• Europe is still trying to come to an agreement for its own internal bailout

Both emerging market equities and debt have paused in their recovery from their March lows. We probably need to see from a fresh catalyst for further absolute gains. COVID-19 challenges are still significant for many with the notable exception of China. Global growth has improved, but global trade growth is patchy hitting emerging countries even harder. With air travel still severely constrained traditional sources of income from tourism have all but dried up.

Not only has global trade been slower to recover, but some countries have found it extremely difficult to limit the domestic impact of the virus on their economies. Economists estimate that in aggregate emerging countries will experience close to a 5% drop in GDP for 2020. Such estimate excludes China. In 2021 there should be a rebound, but the scope of it is highly contingent on further developments in the pandemic and how countries deal with it.

In a recent survey of the damage, Standard & Poors concluded that developments over the second quarter have made it clear that the longer-term impact of the pandemic on emerging countries will be deeper than expected and last for a significant time.

Broad EM economic forecasts miss some stark regional differences. Economists estimate that India, Latin America and South Africa economies face GDP contractions of between 7% to 11%. However, in Asia, two of the bigger EMs in Malaysia and Indonesia face a drop in GDP of 2% to 3%. Emerging Europe is somewhere in the middle of the broader range. Apart from the global trade impact, the worse-than-expected virus containment efforts are starting to show clearly in the outlook for some countries compared to others.

Trade numbers for some emerging countries make for sobering reading. For India and South Africa, export revenues between February and April dropped as much as 60% on the previous year; Columbia saw a 50% drop and Turkey, Russia and Mexico experienced declines between 35% and 40%. These are large drops in significant EM markets. Other countries in the Caribbean and Asia (Jamaica, Thailand, Vietnam) would have experienced traumatic losses in tourist revenues. Changi International Airport, a major hub for such flows of tourism has observed passenger numbers decline by as much as 90% from the previous year, given lockdown measures in source and destination countries.

There is a hope that the likely persistence of very low US$ interest rates will enable EM central banks to run very low-interest rates. However, there is the caveat that localized inflation won’t slow the pace of rate cuts. Last week’s worse than expected inflation in India, due in large part to supply constraints won’t stymie the pace of monetary easing.

In the medium to longer-term, the issue facing EMs will morph from immediate containment strategies to structural reforms to offset the potential permanent damage to economies.

Without doubt debt levels will be far higher. Many countries face disruption to crucial foreign exchange earning industries ranging from commodity exports, industrial exports, and tourism. Debt service levels will rise, taxes might have to increase, and industrial policy faces a challenge. How quickly can economies adapt to a world where global travel may be diminished for a significant period?

The good news is that the worst may be over, but the slow slog to find a “new normal” has just really begun. May onwards has brought some relief on the trade front, as Europe and especially China try to normalize their economies and demand starts to return. Hence the effort of emerging countries to shore up their broken economies should occur in an environment of gradual improvement. Traditional measures such as PMI data and capacity utilization are signalling much the same as some of the newer, data-driven measures such as footfall in shopping malls, use of public transport and the like.

For financial markets, there are several implications. Our view on EM debt is that current spread levels are probably as good as it will get for now. Spreads have narrowed from about 600 bps to 420 bps over Treasuries since March. It does represent a potentially good entry point for the more stable names, but it may be a bumpy ride even then. Investor sentiment is still a bit fragile, and there is downside risk if there are still further disappointments on the economic side driven by ineffective virus containment efforts. For the last two months, EM debt has staged a good recovery, with only a select few countries seeing their bonds trade at distressed levels compared to before the crisis. A combination of much-improved risk appetite, better market liquidity and perhaps a rosy interpretation of the recovery path from pandemic control has fueled this rally in EM debt.

But to return to our original question: where will further support come from? The World Bank and IMF stand ready to provide support, and the market rally has made access to fresh funding a viable option for some creditors. But there are justifiable calls for additional actions ranging from “default-free” restructurings to extended periods of deferral of interest payments.

Equity investors will also have to re-assess their exposures, both from a thematic perspective, and a regional one. In many instances, the clarity of the case for substantial exposure to the domestic growth story in specific markets will now be weaker (Latin America), and more reliable in others (ASEAN). How EM performs relative to developed markets is also an open question, and much may depend not just on the further stimulus (if forthcoming) in the US, but also Europe.

The summit to establish the European Resilience and Recovery Fund, framed as a mix of grants and loans of as much as €750 billion, has descended overnight into a typical EU cliff-hanger. A fierce debate has dragged into a fourth day with complex arguments focused on the mix of grants and loans to be offered from 2021 to countries damaged by the pandemic. The management of distributions is at issue, as is a possible rule of law clause aimed at certain eastern members seen to be undermining EU democratic principles.

The so-called frugal states (Netherlands, Denmark, Austria and Sweden) are taking an unexpectedly tough line in demanding a smaller grant element or more rebates on their annual budget contributions. Germany and France are struggling to win them over even as the Council President repeatedly re-drafts the proposed agreement.

Notwithstanding the likelihood of a special summit re-convening at the end of the month, markets will take a summit collapse badly if it happens. Nonetheless, the nation-state is still in evidence here with the “frugals” having to sell a package to their voters at home. It appears to be down basically now to a change of heart especially by Netherlands and Austria overnight in Europe as Denmark and Sweden relent.

All of these have investors ruing the day they may have bought the bonds in question. Predictably, the energy, retail, and real estate sectors have borne the brunt of the pain. Any renewed lockdown, or even just tighter movement control, could cause an outcome even worse than modelled by the rating agencies.

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