The U.S. Federal Reserve has tried to remind markets recently that its commitment to maintaining an accommodative policy stance while tapering quantitative easing (QE) reflects mutually consistent actions. But some emerging-markets investors are not so sure. Mutual funds have seen significant outflows since tapering entered the discussion in May 2013, prompting concerns that a pullback of QE-fueled liquidity would expose deep problems across developing economies.
Heightened fears about the growth outlook and defaults in China promise to weigh on investor sentiment. On top of that, we have a number of important elections in countries such as Brazil, Turkey, India, Indonesia and South Africa, which collectively are known as the Fragile Five. Another variable to add to the mix is geopolitical risk as events unfold in Ukraine. All of this will generate plenty of headlines, but developing economies face more nuanced challenges. The good news is that these obstacles are not insurmountable, and if addressed satisfactorily, they should provide some attractive investment opportunities.
There is no doubt that growth in many emerging-markets regions has slowed. In some cases, it’s structural rather than cyclical. We should get used to slower growth in China in the coming years as rebalancing occurs. At times it will be bumpy, and markets may overlook the seasonality impact, as we’ve seen this year. Chinese officials have also signaled there may be more defaults on bonds and trust loan products. The fact that China is prepared to address the moral hazard issue is, however, welcome news and suggests that the country is also serious about curbing excesses. Medium-term structural reform, not short-term economic gain, is the policy priority — and rightly so. In the meantime, conditions are ripe for larger defaults than we’ve seen so far, although official support would be likely if a default has systemic implications. A case in point was in January, when the Chinese government rescued at the last minute a large trust loan for mining company Shanxi Zhengfu Energy Group that involved state-owned bank Industrial and Commercial Bank of China .
Investors have reason to be worried about the impact of the 40 upcoming elections this year — including in the Fragile Five — in which billions of people representing some 42 percent of the global population and accounting for more than half of the world’s gross domestic product will vote. But strong central banks, reform-minded politicians and supportive electorates do make a difference, as was evidenced during some of the darkest days of 2013, when currencies were taking a beating. Policy responses in India, Indonesia and Brazil provided support for flagging currencies, while muted responses in Turkey and South Africa forced belated actions and even sharper rate hikes. Assertive policy responses are always critical, but ever more so in periods of heightened political risk around elections. Investors should also look beyond elections to what will follow. A number of countries’ elections this year are likely to return incumbent politicians to power, meaning little will change for those who took to the streets in protest at their politics, and the disenfranchisement that motivated their dissatisfaction in the first place will only be fueled.
Some developing countries might reflect on the halcyon days of quantitative easing and wonder why they didn’t use the time to reform their economies for the days when foreign capital would be more scarce. Bringing about the necessary reforms is going to be more challenging since they will be competing for far less foreign capital. Fortunately, some of the big imbalances are showing signs of improvement. That’s not the case in Turkey, however, where the current-account deficit is nearly 8 percent of GDP. Important to note is that not all developing economies have been so resistant to reform. Mexico’s current-account deficit is only 2 percent, much of it financed by foreign direct investment. It has a strong underlying economy with supportive reform policies, including the recent measures opening up the energy sector to foreign investment, and that should result in stronger growth down the road.
The present emerging-markets dissonance can be a healthy thing following years of excessive optimism. The key for investors in this new phase is to assess whether they’re getting ample compensation for the risks. Even the most cynical would acknowledge that valuations are now much more attractive than at this time a year ago. The political situation adds another level of uncertainty. But this is nothing new for investors in what has historically been a volatile asset class. Fortune favors the brave, and emerging markets will reward the prudent with plenty.
Kevin Daly is a portfolio manager of emerging-markets debt at Aberdeen Asset Management in London.
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