Emerging markets have long been characterized by unique, idiosyncratic factors and higher volatility, especially compared to more established markets such as the U.S., Europe and Japan. This is true despite an expansion of opportunities and greater investor acceptance of these markets over the past few decades, and the graduation of some members to ‘developed’ status, such as South Korea. While the IMF and various index providers classify nations as developed or emerging partially on factors such as per capita GDP, there are a host of other characteristics that separate the two—such as rule of law, enforcement of property rights, financial regulatory standards, political stability, market access and liquidity.
The recent troubles in Turkey and Argentina are emblematic of the occasional potholes EM nations encounter, which are often repeats to those that have plagued them in the past, thereby causing these flare-ups look almost predictable. That is certainly true in the episodes these two nations face today—being among the most troubled in the emerging world—while the difference could be the lower probability of contagion expanding elsewhere. In fact, Argentina hasn’t even been classified as an emerging market for many years—it was demoted to the even less developed ‘frontier’ category.
The strong U.S. dollar has been a catalyst for this troubles for these two nations (as many feared early on for EM in general when the Fed starting raising rates), but that strength and corresponding domestic currency weakness merely exposed kinks in their armor already present. This was true even relative to other emerging market nations—in no small part because this group hasn’t evolved as quickly away from dollar dependence. This was a primary factor in EM crisis episodes of decades ago, which involved Mexico, Thailand and Russia, among others, at various times. A major catalyst back then, and of these selected emerging nations today, is that overall debt was sizeable (as a percentage of GDP), and worse, it was almost always denominated in dollars.
This issuance of debt in dollars is now referred to as the ‘original sin’. But why would they do this? In early stages of EM development, investors didn’t trust the volatility of these individual currencies, so denominating the debt in a more stable currency like the USD became a condition for lending in the first place. This placed the burden of foreign exchange risk on each EM nation’s treasury to ensure enough reserves were available as a buffer to withstand currency fluctuations—as a stronger dollar and correspondingly weaker domestic currency unit could increase the debt burden dramatically. (Which it did—if a nation’s domestic currency were to fall by -50%, it effectively doubles the amount of debt owed in U.S. dollar terms.) When the debt burden became too much, these nations couldn’t pay—and were often bailed out by the IMF in some type of relief package. Since the debt was in dollars, bond investors didn’t have to take on currency risk, but the credit risk ended up being substantial and represented the bulk of the yield premium demanded for these types of bonds.
As the decades wore on, some EM nations evolved and became more established. This was marked by more predictable and less arbitrary fiscal and monetary policy, and often stronger and more stable political regimes. For the strongest nations, this led to the ability to issue bonds in their own local currencies—which effectively moved the currency risk away from the EM nation’s treasury and transferred it to the end investor. While nations often had to pay a higher interest rate due to the higher risk associated of currency fluctuations, the seeming ‘cheapness’ of EM currencies and trajectory of fundamental improvement appealed to institutional investors eager to earn both a higher yield as well as take advantage of potential price appreciation from currency movements. This worked out better in some cases than in others, and still remains very much a bottom-up country-by-country endeavor. While this currency element can add to portfolio volatility (relative to the USD-denominated market), it has allowed for better stability for emerging market borrowers, who became less tied to foreign exchange markets. In this sense, investors have traded credit risk back to currency risk. Note in both cases, the risk is still present—it’s a matter of who absorbs it.
This leads us to the two current nations under the spotlight—both of which, unsurprisingly, have extensive borrowings in U.S. dollars. Turkey has been led by a government initially focused on integrating the nation into the broader core of Europe (and hoped-for EU membership). However, along with apparent moves away from a secular path on the societal side and pressure on the central bank to keep rates low despite high inflation, a cash crunch has emerged. Argentina faces a similar situation, due to the dollar’s strength and peso’s weakness, requiring a $50 bil. emergency loan from the IMF. Despite a new political regime, and optimism from many investors about Argentina’s future prospects, it could be a difficult road in the interim.
A key risk is that many investors lump these nations together into one intermixed ‘EM basket’. In such a case, investors implement positioning in terms of ‘risk on’ or ‘risk off’, which explains some of the herding tendencies affecting this group on a macro level. This is true of both stocks and bonds. It’s been seen in the pattern of investor cash flows, which can be extremely fickle in this space from month to month. ETFs haven’t necessarily helped the cause, as investors seek generic index positions as opposed to differentiating between stronger and weaker constituents. However, there have been underlying sub-classifications in EM that have become much more bifurcated—such as state-owned vs. private enterprises, cyclical vs. less cyclical sectors and companies, oil exporters vs. importers, and those sensitive to global exports vs. an increasing segment focused on internal domestic demand. The evolution of these nuances represents the primary difference between emerging markets a few decades ago relative to today.
It would be naïve to think emerging markets overall don’t face challenges, which include a potential deceleration of growth in developed markets, ongoing uncertainty and potential aftermath of tariffs and more restricted trade and, as discussed, ongoing dollar strength. However, improving long-term fundamentals and growth trends, particularly in the higher quality segment, remain in place. In fact, aside from tax cuts helping the U.S. economy, these are the only nations on the globe growing to any reasonable degree—driven increasingly by domestic consumption as opposed to only by exports as in the past. Based on traditional metrics, valuations are also more compelling than most other asset classes in the world today, which, as we know, often go hand-in-hand with more uncertainty and weaker sentiment, but can also correlate to greater forward-looking return potential.