Three signs that EMD could be nearing a tipping point
Historically there are three sell signals in the emerging market (EM) cycle that investors need to see before they start buying EM again.
It appears we may have already reached these checkpoints.
1. Strong US dollar = Sell EM
The US dollar (USD) has strengthened by over 7.5% since 16 April, while year-to-date the EM USD-denominated sovereign bond index is down 4.9% and the local currency-denominated index is down 9.5%.
2. US dollar strength creates EM and international cracks = Sell EM
This is when EM countries with the largest external financing needs, mostly measured by current account deficits, come under market pressure. Turkey and Argentina are two such countries.
Turkish bonds denominated in USD are down more than 15% and the Turkish lira is down over 25% so far this year. Meanwhile, Argentine USD bonds are down over 16% and the Argentine peso is down 33%.
3. Policy response fitfully addresses liquidity stress = Sell the last bits of EM
We are here!
Argentina has received IMF funding and revamped monetary policy, reducing currency volatility.
Turkey has imposed restrictions on Turkish lenders using lira in foreign exchange swap transactions, with the effect of raising trading costs for foreign speculators and to crack down on investors shorting the lira. It also secured some funding from Qatar, and promised further fiscal measures.
Indonesia, while out of the centre of the storm, has raised interest rates to slow growth and address market concerns proactively. The results are uncertain and markets struggle to balance better policy frameworks against terrible investor sentiment. In only the first two weeks of August, the dollar sovereign index has fallen 1.7% and local currency index is down over 5%.
Once we’ve seen these three events, the next step traditionally has been the tipping point.
4. The tipping point: Developed market events cause a turn in liquidity = Buy EM
Should the international or EM stresses begin to affect the US fundamentally, the Federal Reserve would hint its hiking cycle is winding down. This is what kicked off the very strong EM recovery from early 2016 through 2017.
A slowdown in the US exacerbated by a too-strong dollar or a sharp equity correction for any reason could do the same. Negative trade war effects impacting the US would have a similar result.
When will the tipping point arrive?
The distance from step 3 to step 4 is the great unknown. The extent of the selling we saw in August, however, logically increases the odds that markets have opened up a margin of safety for investors, providing some reassurance to would-be EM buyers while we wait for the fourth step to materialise.
As with many turning points, this moment will likely only be apparent in hindsight.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.