EMD Relative weekly notes
Week Ending April 15, 2016
We often focus on the importance of liquidity flows into emerging markets and their correlation with asset price movements. Despite a more subdued market tone this week, those flows continue. Recent foreign exchange reserve numbers continue to grow in aggregate. There have been eight consecutive months of inflows into EM bond funds, with four of the last six showing $1B plus inflows, which followed six consecutive weeks of outflows. While this liquidity indicator is not as closely linked to asset price movements as some others, continued inflows suggest that at a minimum recent price gains in the asset class are unlikely to fade quickly, in our opinion, without a meaningful negative driver coming to the fore.
Another aspect of the recovery in sentiment towards emerging markets is a nascent improvement in political dynamics across many countries. After deeply negative headlines in 2015 for China, Russia, and Brazil, this is a welcome development. The stabilization of China sentiment has continued with a drop in reserve outflows and growth that, while credit driven, has diminished fears of a sharper slowdown. Brazilian political developments have been the primary driver behind best-in-class performance for asset price appreciation, as it now appears very likely that President Rousseff will be impeached. Though the future beyond that is cloudy, it is undeniable that hopes for a better policy mix are warranted. The first round of the Peruvian election last week leaves the country with a choice of two candidates both perceived to be market-friendly. This week Mexico announced a re-capitalization plan for state oil company Pemex that, while only a small step, affirmed that the sound policy direction towards rationalizing the company's operations is continuing. Indonesia remains a country with good growth and the policy space for counter-cyclical fiscal and monetary easing. Politics in Turkey have been stable, while growth, inflation, and the current account deficit have all surprised positively.
Argentina has become the poster child for political turnarounds, as the new president has moved quite swiftly to turn around a terrible policy mix and open the country to markets after a freeze of more than a decade. A new benchmark bond issue coming this week will underscore the beginnings of that turnaround. Initial indications are that investor reception will be very strong, leading to more positive headlines about the country and the asset class in general this week.
While this news is welcome, history tells us EM politics oscillate in a wide range from being a market focus to being studiously ignored, thus future developments are often unanalyzable. But what is undeniable is that the practice of politics becomes easier under favorable conditions. Politicians across the spectrum have labored for the last three years under the headwinds of a stronger US dollar, significantly weaker currencies, capital outflows and slower global growth in general. Pundits often conclude that politicians are a lot less smart and capable when managing countries under these constraints. With the current tailwind of appreciating currencies, more stable commodity prices, and loose monetary policies unanimously applied in developed markets, liquidity and inflows return and all of a sudden politicians have become much smarter and capable as this results in improvement in growth and employment.
The lesson is that, far more so than in developed markets, positive investor sentiment and liquidity creates a virtuous cycle that manifests the conditions for “second order” effects--economic performance and political stability--to flourish. We are seeing initial signs of that happening now.