Global risk-off events are becoming an annual ritual. In the past five years it has been triggered by European debt concerns (2011 - 2012), taper tantrum (2013), the big commodity correction (2014) or fear over growth in China (2015). Weaved into these events were U.S. political and policy uncertainties.
Do you remember the worries about the U.S. losing its AAA status, the fiscal cliff and, oh yes, the uncertainties created by the end of QE1, QE2 and QE3? These annual corrections were prevented from becoming systemic threats thanks to an array of unconventional policies – note to self, stop using the term “unconventional” because after five years surely these policies are closer to “the norm” than “unconventional”. Every time things got a bit scary, policy action and/or political decisions turned the tide. I can’t resist going down memory lane for a moment: QE1, QE2 and QE3, Twist, OMT, LTRO, T-LTRO, QQE, sequestration, competitive devaluation – oh, those lovely policy “put” days. Cyclical assets rejoiced every time the policy “put” was confirmed. Since 2011, emerging market equities had rallied roughly 20% (in USD) at least five times. On average, that’s a 20% rally every 12 months. This sounds pretty good to me!
But this has been a true rollercoaster ride. Every time emerging market equities were about to break out into an uninhibited bull run, the mallet came down. Policy action could only help so much before the euphoria died down and investors started looking beyond the here and now. They started questioning the efficacy of these policies and wondering about exit strategies. They wanted to know how much fundamental realities have really changed, and how long can global growth be propped up by policy makers? The rally fizzles out and turns into a selloff that in turn leads to a more significant correction until policy makers play yet another “policy put” card – and so the ride continues.
This brings me to the recent selloff. Developments already look more ominous than the previous five corrections. Fundamentals have taken over with increased growth concerns across the emerging market world as a realization sets in that China’s growth is both slowing and changing from a commodity-heavy growth model to services and consumers. All of this is casting a dark shadow over commodities and commodity-exporters. Not only will policy action in China not change this trend on a sustainable basis, but Beijing is highly committed to the rebalancing in the economy and seems willing to accept lower growth in return.
This leaves the commodity-producing emerging markets in a precarious spot. Most of the commodity producers have not embarked on any major structural reforms to date, leaving them even more vulnerable if commodity prices remain depressed for a sustained period (our base case – commodity prices are not necessarily lower than current levels, but there are no eye-popping improvements either). No wonder S&P decided to downgrade Brazil’s sovereign credit rating to below investment grade.
A number of commodity-importing emerging markets had in turn relied heavily on credit expansion to sustain high growth rates in recent years. Although with corporate and household leverage quite extended and banks’ leverage ratios (LDRs) on the high side (a few exceptions in Asian emerging markets), one wonders where the next growth impetus will come from. Across emerging markets, policy makers are hoping for capex to be the next big driver, but like developed markets, private sector capex had and will likely continue to lag rather than lead growth in this business cycle.
What remains uncertain is whether these conditions lead to an outright financial crisis or a major liquidity event. Higher volatility and uncertainty will in all probability keep emerging market assets from staging any meaningful rally – barring a policy put or growth stabilization.
Will we get a policy put? Will policy makers be able to comprehensively ease financial conditions and reflate economies and expectations again? How high is the bar for the Fed to turn outright dovish or Beijing to announce a sizable fiscal stimulus? Will new monetary policy have the same impact: lift short-term sentiment without raising doubt of the longer term effectiveness of these policies? Could policy makers come up with more extraordinary measures that will shock and awe the market? These are the questions that need to be answered before contemplating the sixth policy-induced upswing in emerging market assets since 2011.
Rather than second guessing the policymakers, we prefer to respect the emerging market fundamentals, opting for reduced volatility and waiting for selective investment opportunities. Even though the environment remains challenging, rather than staring blindly at this group called “emerging markets”, we continue to focus on countries, industries and companies that should continue to outperform – despite these headwinds. India, Mexico, Philippines, non-industrial China and emerging market banks with strong balance sheets all fall into this category.
As a side note, we believe that these changes in emerging markets are the beginning of more significant structural changes and will alter investors’ view about how to invest in these markets over the longer-term…but that’s a discussion for another day.