It’s a cliché that not all emerging markets are the same, because it’s true.
Nor does everyone use the same definition of what an emerging market is: some will point to living standards and economic growth, others to the rule of law or governmental structures, still others to the depth of a financial system or capital markets.
From a macro investing standpoint however, perhaps the key consideration when dealing with emerging market currencies is the propensity for equities, government bonds, and currencies (for overseas investors) to be correlated: with inflation acting as the correlating factor.
Eric has outlined this mechanism on his own blog; in short: the structure of emerging market economies often mean that inflationary forces prompted by currency weakness are often long-lived a self-perpetuating, with policy having to be tightened rather than eased in response. As Carl discussed last week, the role of foreign capital and debt levels only exacerbate these challenges.
In developed markets such currency-driven inflation will often be short-lived. Consider the UK after the Brexit referendum, where a one-off shock to Sterling did not leave inflation rates permanently higher or prevent the Bank of England from easing policy.
By contrast, the UK in the 1970s was hit by ‘stagflation’ since inflation was embedded by a wage-price spiral and conditions could not be eased to support growth.
A changing landscape?
In developed markets the shift from the dynamics of the 1970s has been key to the regime for multi asset investors. A more benign inflation environment (driven primarily by globalization) has not only meant strong returns from fixed income assets, but also accounted for the safety properties that investors now take for granted.
When we look at prevailing yields on government bonds today a clear distinction between developed and many emerging government bonds is their correlation with their respective equity markets.
In figure two, the cluster of countries toward the bottom left shows that low real yields are typically associated with negative short-term correlations (i.e. bonds can provide protection against equity weakness). On the right hand side, traditional emerging markets like Brazil and South Africa are characterized by positive bond-equity correlation, and higher real yields.
What is notable is that many countries often considered emerging, such as Korea and Chile, are now sitting on the left hand side of the chart. The question for investors are: if globalisation and its impacts on inflation is a widespread phenomenon, should we expect more emerging markets to migrate to the left hand side of the chart, and what, if any impact might the pandemic have on that process?
The COVID test?
In the panic phase of market response to the pandemic, many investors appeared to follow the ‘risk off’ playbook, selling off emerging market exposures. Of the five economies highlighted in figure two, four saw their currencies fall by over 20% (from the start of the year to 23nd of March), and the Indonesian Rupiah fell by 15%.
And yet all five economies have seen policy makers cut rates, often quite significantly since the start of the year.
We know that this period is not a ‘normal’ recession. As I wrote in April the inflation considerations for all economies are unusual and complex, and it is clear that the nature of the shock has put the immediate need to support economies well ahead of longer term worries (justified or otherwise) on the priority list.
However, the ability for emerging market economies to ease policy into such weakness is notable, both in terms of the numbers of countries involved and the magnitude of steps taken. This represents a huge potential departure from the central bank response function that we’ve gotten used to as investors over the years.
For all the talk about these times being unprecedented, most commentators’ prognostications for the post-pandemic world often resemble the arguments they were making before the virus.
Whether it be the future of work, the importance of ESG investing, or the need for certain economic policies, most arguments simply amount to a confirmation of previous beliefs or an intensification of forecasted trends.
This isn’t a surprise; most of us have a hard time conceiving of the genuinely unprecedented. Nor does it make these arguments wrong; it seems hard to argue that the experience of the pandemic will speed up the trend in working from home for example.
For emerging markets the response to the pandemic represents a test of the hypothesis that more emerging markets are coming to resemble their developed counterparts. The long term trend for convergence in inflation dynamics, is nothing new:
The question is whether this trend might be intensified by the experience of the pandemic.
For the moment the market certainly doesn’t believe that emerging market bonds can be a safety asset, and though globalisation should impact inflation in all economies, there is clearly scope for domestic policy to counteract its positive effects (and not just in emerging markets) and reverse positive inflation dynamics. Some have even argued that the pandemic itself will intensify threats to globalisation more broadly.
However, if faced with tests like the pandemic, emerging markets show themselves to ease into crises rather than see policy tighten, it would mean a significant shift in both the potential return profiles of emerging market fixed income assets, their risk properties, and their position in multi asset portfolios.