Asset Class: International Equities

Contested development: Emerging markets on fragile footing

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Rising U.S. interest rates and the trade war are destabilizing many emerging markets. The most vulnerable are those with substantial external debt denominated in foreign currencies (mainly the U.S. dollar) together with current account deficits.

Countries that feature prominently in both categories are Turkey, Argentina, Columbia, South Africa, Chile and Indonesia whilst slightly less prominently, but nevertheless with a foot in both categories, are Mexico and Brazil. Hungary, Poland and Malaysia (in that order) have very sizable external debt relative to GDP but are running current account surpluses (OECD data as at the end of 2017).

The two countries that have experienced the most dramatic depreciation of their currencies this year are Argentina and Turkey (excluding the Venezuelan horror story). The Argentinian Peso has depreciated by 50% relative to the US dollar and the Turkish Lira by 40%.

 
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Mr. Trump has hit Turkey with tariffs of 50% on steel and 20% on aluminium. The U.S. is Turkey’s leading export destination for steel so the impost is painful. The genesis of this skirmish is a diplomatic row with the U.S. over a detained U.S. pastor, but inevitably it has broadened to include all sorts of unrelated issues. Domestic inflation has passed the mid-teens and the Turkish central bank has now raised its key interest rate to 24%.

Turkey’s foreign debt includes at least U.S. $150 billion owed to European banks – mainly Spanish, French, German and Italian (Bank for International Settlements data) so that there are many vested interests watching this situation closely.

Argentina has been battling extremely high inflation (over 30%) and the key central bank interest rate is now at 60% (raised from 45% in August). Most of the country’s debt is denominated in U.S. dollars. The President of the central bank has now resigned for “personal” reasons after just three months in the job – in the midst of critical discussions with the IMF. This is the sort of situation the word “disaster” was coined for.

The fragility of emerging markets is often underestimated. They generally experience faster average growth than the advanced countries but they depend heavily on foreign direct investment and credit, trade growth and political and currency stability (perhaps a better term is “certainty”) – none of which can even be remotely guaranteed. In the meantime the intricate web of global connectivity is all too easily upset by economic initiatives in the advanced world which have a disproportionate impact on the emerging economies.

We have always been enthusiasts for the emerging world – provided a long-term view is taken. Volatility must be expected and accepted along with the occasional disaster. The lesson is to avoid those heavily reliant on offshore borrowings whilst running current account deficits but that does reduce the size of the audience somewhat. We suppose the pragmatist would point out that one of the lessons from the recent financial crisis is that even the advanced world can get it horribly wrong (and often 40 does) so perhaps it is best to avoid preaching altogether.

 

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