Emerging market jitters cast shadow over investment horizons

Lurking in the shadows of every bull market run are fears it will suddenly come crashing to a halt. All through 2017, a stellar year in which many strategies have made money, investors have been looking for signs of “the turn” — and this week a few came into view.
All kinds of asset classes have experienced jitters — from junk bonds and US stocks to commodities — which are arousing various measures of market volatility.
Such angst, however, has been registering across emerging markets a good deal longer. Once more the catalyst appears to be China, the engine for which so much of EM depends.
The memories of the market corrections of August 2015 and January 2016, sparked by worries of an economic slowdown in China, are painful for many EM investors. Those memories lay dormant during 2017, a year of benign conditions and soothing newsflow from China leading up to the Communist Party congress last month.
The aftermath has seen October data reveal a slowdown in economic activity and this week prompted a rise in 10-year bond yields to their highest level since 2014, prompting a big injection of central bank liquidity to calm the waters.
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Moreover, Zhou Xiaochuan, the central bank governor, whose warning during the congress of a “Minsky moment” was largely ignored, has been stepping up his rhetoric, voicing fears of systemic risk from excessive financial leverage.
The repercussions of China wobbles have duly registered in commodities because of its vast consumption of raw materials — hence this week’s falls in iron ore, copper, nickel and oil. When China sneezes, other EMs — many of them big commodity producers — are quickly exposed to contagion.
China worries, plus expectations of a US interest rate tightening next month and political developments in Venezuela, Zimbabwe and South Africa, are “salient reminders” going into the year-end of the risks that can appear in EM, says Simon Derrick, BNY Mellon strategist.
EM currencies had a good 2017. The year to September 7 delivered a rise of 8.9 per cent in JPMorgan’s EM currency index, a reflection of the dollar’s weakness, global growth and the improved fundamentals in the economies of many leading EM countries. But since that date, the index has slipped 5.4 per cent.
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The widespread assumption has been that even though EM is coming under strain from the dollar’s revival, its excellent value and healthy prospects would see it withstand the pressure.
The growth backdrop for EM remains strong, says Wike Groenenberg of BNP Paribas, with exports running at their strongest level for many years, particularly in Asia and central Europe — yet the market wobbles this week are causing concern.
“We are more and more worried that the outflows we’ve seen in some assets lead to outflows in others,” she says.
EM forex should fare well if the US dollar continues to come under pressure, especially if the US administration ends up disappointing on tax cuts and special counsel Robert Mueller’s Russia investigation widens. But the fear is that EM forex may become victim to investor insecurity.
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“People are getting increasingly nervous,” says Sacha Tihanyi, EM strategist at TD Securities. “They want to protect their profits and take money off the table, so volatility gets bigger and positions get reduced.”
Mr Derrick looks at the reach for yield in EM and concludes it is “simply not what it was”. How else to explain the steep falls in the Turkish lira, the Brazilian real and the South African rand since the start of October despite a widening in the yield gap between US Treasuries and their respective government bonds.
Risk aversion was certainly on the rise this week, a sentiment evident in the appreciation of haven assets such as gold, the yen, the Swiss franc and, to some extent, the euro. “Investors may also be paying the price for building up substantial long positions in EM and other risky assets over the summer months,” says forex strategist Valentin Marinov at Crédit Agricole.
However, not everywhere in the EM universe is wobbling. Asian assets are faring quite well, notably the South Korean won, up 2.5 per cent against the US dollar this week, amid strong growth and rate-tightening speculation. So, too, are the currencies of the Philippines, Malaysia and Thailand. A sovereign ratings upgrade for India on Friday from Moody’s drove the rupee higher.
“There is certainly a trend in Asian currencies becoming less correlated to EM and doing their own thing,” says Peter Kisler, who runs North Asset Management’s EM fund.
And EM advocates are holding their ground. If China is indeed the source of market nervousness, it is of a different order to the 2015 and 2016 sell-offs, according to Xavier Hovasse at Carmignac. “There is a better understanding of China today,” he says. “The perception has probably improved.”
Investors should not assume markets are about to go into reverse. Shaniel Ramjee at Pictet Asset Management says after a year in which markets have “run pretty well” with little volatility, it is not surprising that investors are “taking a bit of a breather”.
The lessons of recent weeks, Mr Ramjee adds, is that investors are becoming more wary about some risk-taking parts of the market and need to be more discerning about where to put their money.
If that slows the speed of markets next year, so be it. “In 2017, you made decent money wherever you were,” says Mr Ramjee. “In 2018, that’s going to change.” Additional reporting by David Sheppard