Emerging markets have faced easier financial conditions in recent weeks after a period of intense pressure. The sense of a heightened risk of a generalised asset-class shock has given way to relief among not just investors, but also policymakers in advanced and emerging countries, as well as in international institutions.
Policy adjustments in individual countries have had a beneficial impact. Yet the big change has been a less hostile external environment, from a weaker dollar and lower oil prices to looser financial conditions for emerging economies. But before relaxing more, these economies need to realise that some of the external relief could prove both temporary and reversible, raising important issues for policy priorities.
By the beginning of September, the spread on emerging-market bonds denominated in foreign currency had widened to 406 basis points compared to a low of 288 basis points on February 1 and 311 basis points at the beginning of the year (as measured by the JP Morgan EMBI Global spread index). Coming on top on higher US yields (the 10-year Treasury has risen by almost 80 basis points since the start of the year), this has translated into higher borrowing costs for both sovereign and corporate debt while handing investors a year-to-date loss of 6 per cent on what is usually the least volatile and fragile sub-segment of emerging markets.
The JP Morgan EM currency index also hit the year’s low around the beginning of September, losing almost 19 per cent year-to-date. By that same time, EM stocks had fallen 12 per cent, as measured by the emerging markets ETF EEM, and were underperforming the S&P 500 index by 20 percentage points. And one of the most intense problem cases, Argentina, was in the midst of renegotiating an agreement with the International Monetary Fund after a first deal that failed to stabilise its currency. The currency in Turkey, the other problem case, had depreciated from 3.80 to the dollar at the beginning of the year to almost 6.70, and remained fragile.
Market tensions have eased since then. The average spread on external bonds tightened by 50 basis by the beginning of October, and now stands at 376 basis points. EM currencies have staged somethhing of a recovery, gaining more than 3 per cent. Argentina concluded a new agreement with the IMF involving a reinvigorated policy framework and augmented financial support, laying the foundation for an appreciation in the currency.
Turkey's lira has also strengthened, closing last week’s trading session at 5.65. EM stocks however, have remained under pressure; EEM recorded a year-to-date loss of 15 per cent as of October 19, still under-performing the S&P by around 20 percentage points.
Individual country policy adjustments played a role in changing markets and investor sentiment. Depending on the country involved, these changes included interest-rate increases to stabilise foreign-exchange markets, tighter fiscal policies, additional promises of pro-growth structural reforms and more countries approaching the IMF for financial support.
However, as this has remained a rather partial policy effort overall, the improved EM conditions would have likely not materialised without some relief on the external front. Since early September, the DXY Dollar Index has depreciated by just over 5 per cent, oil prices have retraced their high as has the yield on 10-year government bonds (albeit to a lesser extent).
Whether some of these more recent trends will continue remains an open question. Specifically, behind these calmer markets conditions for emerging markets we have seen an intensification of four forces that would suggest renewed dollar strength and higher interest rates may lie ahead:
- Growth divergence in economic fundamentals among advanced countries, with the widening US outperformance taking the yield differential on benchmark 10-year government bonds issued by the US and Germany to the historically elevated level of 270 bps at the end of last week;
- A reiteration by the Federal Reserve led by chairman Jerome Powell of its rather aggressive interest rate guidance as the US economy gathers further momentum, inflation edges up and the Fed seemingly pays more attention to the risk of future financial instability;
- Remaining uncertainties about the global trade regime; and
- Renewed concerns about the momentum of the Chinese economy.
This list does not include other risks identified recently at the IMF-World Bank annual meetings, such as lack of room for policy flexibility and historically high debt levels, as well as the growing tensions over budgetary policy between the new Italian government and the European Commission that led Moody’s to downgrade Italy’s sovereign credit rating to Baa3, just one notch above junk.
The best way to think about emerging markets is in the context of a bigger ongoing regime change: a transition away from ample, consistent and predictable injection of central bank liquidity, and toward a more fundamentals-driven global economy and markets that is being undertaken as the balance of risks is tilted toward the downside. This shift is far from easy, especially as it heightens the risks of both policy mistakes and market accidents.
Rather than hope for the recent market calm to continue, emerging economies should plan on the possible return of more externally induced pressures. To this end, they should continue doing all they can to increase their financial resilience and enhance economic agility. The resulting benefits would extend beyond the individual countries. The more this is done, the less the risk of disruptive winds of contagion throughout what remains a technically fragile asset class.
Mohamed El Erian is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include The Only Game in Town and When Markets Collide