A key development in capital markets since mid-April has been the strengthening of the US Dollar, gaining back some of the ground lost in 2017. Whether it can persist is unclear at this stage, given the large increase in Government borrowing that will occur to fund the recent fiscal giveaway. Nevertheless, the move to date has begun to put pressure on emerging market currencies and bonds in particular, and could remain a focal point in coming weeks.
Thus far, most of the pressure has fallen on two countries; Turkey, where the Lira has depreciated around a quarter year-to-date, and Argentina, where the Peso has fallen by nearly one-third. There are specific reasons behind the significant depreciation seen; Turkey on political concerns, which has weighed on the credibility of monetary policy, and Argentina on lack of progress on structural reform and significant inflationary pressures. This has led to investors focusing attention again on the sensitivity of emerging markets to higher US interest rates and the US Dollar, particularly on those countries and companies which have borrowed heavily in US Dollars or rely heavily on large inflows of foreign capital to plug current account gaps.
According to the Bank of International Settlements, Dollar denominated credit to non-bank borrowers outside the United States increased by 8% last year to $11.4trillion, of which emerging markets account for $3.7trillion. Emerging market borrowing grew by 10%, and there was an ‘unprecedented’ 22% surge in debt issuance in the second half of the year. Bloomberg estimate that approximately $249billion of this debt needs to be repaid or refinanced over the next 18 months. Investors have been willing to purchase this debt, which can be observed through the significant inflows into emerging market assets through 2017, although the willingness to continue to do so may be tested going forward.
There is, of course, a reason why emerging markets have been attractive to foreign investors, and why, with the exception of a few outliers (Argentina and Turkey the current examples) fundamentals remain sound. Global growth remains supportive, and foreign exchanges reserves for many countries are healthier than they were when the asset class was last really tested, during the 2013 taper tantrum.
To date, the impact on emerging market assets has primarily been focused on currencies and bonds, with The J.P. Morgan Emerging Markets Bond Index down 4.3% year-to-date. It has also weighed on emerging market equities to a certain extent, which have not participated in the rally we have seen in other markets from the February lows. From here, much will depend on what impact quantitative tightening has on bond yields, and also the US Dollar, and therefore remains a watching brief.