Financial markets across the globe have been impacted by the unprecedented monetary policies of the post–crisis period. The expected reversal of some of these policies could have significant effects, particularly on emerging markets equities.
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The unprecedented monetary accommodation in major developed economies, and particularly the US, has had an evident impact on risk aversion: liquidity injections coupled with high visibility on the future path of central banks’ policy rates have driven investors across the globe to increase their investment risk across asset classes. Emerging markets asset classes have not been an exception and large inflows in emerging markets initially resulted in positive effects. Indeed, investment flows in emerging markets economies supported growth and investment in the domestic economies. At a second stage, excessive debt financed growth resulted in imbalances which have been put to a significant test since the ‘taper tantrum’ of 2013. A specific area impacted by low risk aversion and abundant liquidity is emerging markets corporate debt, which has grown by more than a trillion dollars since the financial crisis of 2008. Naturally, easy access to financing has had an impact on corporate leverage, increasing the fragility of a large number of emerging markets companies.
Corporate balance sheets
The incentives for emerging markets companies to finance their growth in international markets have been high over the past few years given the low level of US interest rates but also better access to corporate bond investors globally. The strong appreciation of emerging markets currencies until 2012 also benefited companies as foreign flows accelerated. These closer links to international markets have been beneficial but have made some emerging markets companies potentially more vulnerable to external shocks.
The risk for emerging markets companies in an environment of US rates normalization comes not only from the accumulated level of corporate debt but also from foreign exchange mismatches with local currency revenues. Since 2010 and up until the first half of 2015, net issuance of international bonds by emerging markets companies has been significant with a cumulative $1.34 trillion. This increase in leverage goes beyond the banking sector as non-financial private companies account for nearly 63% of net issuance.
These dynamics raise the question of currency mismatch in the balance sheets of emerging markets companies. The sensitivity to rising rates and a stronger US dollar differs across regions and industries. In countries with large current account deficits, such as Turkey, Brazil and South Africa, companies may find it more difficult to service their debt given the sharp slowdown in their respective domestic economies and more difficult financing conditions. In areas where the cost of hedging is high and the derivatives market less sophisticated, currency mismatches in balance sheets remain unhedged. For example, according to Fitch ratings, companies in Latin America have a high level of foreign currency denominated debt accounting for 62% of the total debt outstanding (as of September 2014). Outside the commodity sector in Peru, currency hedging in corporate balance sheets is minimal. Even in Brazil, where the derivatives market is more developed, companies only partially hedge their exposure.
Asian companies seem to be in a better position overall to absorb these shocks as the proportion of their debt that is denominated in US dollars is not meaningfully higher than the proportion of US dollar revenues. There are exceptions however, with property developers in China who saw their dollar denominated debt rising substantially while most of their earnings are in renminbi.
Therefore, the FX mismatch issue is not widespread across all emerging markets and remains, in our view, more of an idiosyncratic risk for emerging markets corporates, rather than a systemic one.
Since the ‘taper tantrum’ in 2013, both emerging markets equities and currencies have seen sharp falls and even the Chinese renminbi, once perceived as the most stable emerging markets currency, has seen downward pressure. In 2015, outflows from the asset class outstripped the 2008 financial crisis levels. This environment would suggest that emerging markets equities are trading at depressed valuations. This is the case relative to developed markets as emerging markets equities are at a 35% discount to the MSCI World on price to book multiples, levels not seen since June 2003. However, relative to their own history, the valuation picture for emerging markets appears more mixed.
Brazil is a prime example. The country seems trapped in a low growth/high inflation spiral and is in the middle of political turmoil due to accusations of corruption against members of President Dilma Rousseff ’s own party. Despite a sharp sell-off in the Brazilian equity market over the past year and a significant depreciation of the real, forward looking earnings multiples are still above their 10-year average. This is due to meaningful earnings downgrades for Brazilian companies.
Therefore, we do not believe that current valuations in emerging markets warrant a more positive tactical view at this stage, and the normalisation of monetary policy in the US is still a near-term risk for emerging markets earnings.
Impact of monetary policy normalization
The reversal of the unprecedented monetary policy in the US is a subject of intense debate across the entire investment community. Emerging markets are naturally at the centre of investor concerns with regards to their vulnerability to this change in policy. Emerging markets already faced a significant test during and after the ‘taper tantrum’ of 2013. Back then, the perception of a change in policy had major repercussions across financial markets. An abrupt reversal of risk appetite had a very negative impact on emerging markets: a sharp reversal of flows from emerging markets resulted in sharp sell-offs in equities, credit and currency markets.
As opposed to previous episodes of emerging markets weakness, investors clearly differentiated between markets based on their macroeconomic fundamentals. In particular, countries with weaknesses in current account deficits, short-term external debt and overall levels of debt were the most impacted. As highlighted above, negative sentiment and subsequent outflows from emerging markets economies has not reversed since the 2013 episode and have even accelerated significantly in 2015.
It could be surprising to see these events unfold before the US central bank takes any concrete action on monetary policy. However, financial markets tend to adjust to events which have a strong consensus, such as the reversal of US monetary policy. Similarly to the 2013 episode, emerging markets economies with weaker fundamentals have been penalized the most. However, most emerging markets currencies have seen sharp falls which in turn have impacted US dollar based investors and further accelerated outflows. Emerging markets economies face a significant dilemma and are paying the price of complacency as the pace of reforms was not a strong focus during the years of easy credit.
In this context, the majority of our selected third party managers tend to avoid companies with high debt and focus instead on cash flow generative businesses. More importantly, managers are paying close attention to potential revenue and debt mismatch in companies’ balance sheets and have identified pockets of risk in different sectors. This includes Turkish property, Malaysian state-owned enterprises (SOE), highly geared Brazilian companies and Chinese real-estate developers, as well as industrial and textile exporters. FX exposure is an integral part of the managers’ bottom-up analysis and, where companies exhibit some foreign currency debt, this is mitigated in most cases by natural hedges through exports with a high percentage of US dollar earnings.
The views regarding the current environment and the magnitude of these issues can differ substantially between managers. One of our Hong Kong-based managers thinks that risks are rising substantially following the devaluation of the Chinese renminbi. While he is not predicting a massive renminbi depreciation as China still has some growth and high savings rates, the break of the de facto US dollar peg would likely have unintended consequences, which is a tightening of domestic liquidity conditions. This can create tensions in broader markets and end up exporting deflationary pressures globally. Therefore, the portfolio is positioned defensively in cash flow generative and sustainable yield names. With deflation likely to get entrenched he remains wary of all companies with high debts – particularly in commodity and cyclical sectors. Other areas which he continues to avoid are asset plays, capital intensive names, oligopolies, chaebols,2 SOEs and marginal producers.
Other managers seem less wary. They point out that in China, while the currency has been allowed to depreciate recently, the authorities are encouraging sectors with FX exposure, notably real-estate developers, to issue local currency bonds. Despite their significant rise, external corporate bonds account for a small amount of external debt in emerging markets countries, ranging from 3% of GDP in Asia to 9% of GDP in Latin America. The managers believe that emerging markets banks tend to use FX funding to finance foreign currency loans in order to ensure assets and liabilities are matched. However, this risk can be masked as end borrowers might be exposed, such as in Turkey.
Despite these polarised views, managers are preparing for a prolonged period of volatility, which means that selectivity and active management remain crucial in emerging markets investing.
The market sell-off during the summer will most certainly have significant implications. From a macroeconomic perspective, significant issues like massive capital outflows, lack of fiscal flexibility, poor governance and, in some cases, geopolitical conflicts result in very difficult conditions for emerging markets governments. From an investor perspective, the long-standing expectation of higher growth and higher returns of emerging markets equities versus developed markets equities is considerably shaken. Although large outflows have already taken place, it is unlikely that a reversal could take place given the significant obstacles described above. As emerging markets equities remain part of a diversified portfolio, using active unconstrained managers is more crucial than ever.