Investors should review their emerging market exposure and look for potential problem countries following recent tumult in Argentina, according to several market commentators.
In an unprecedented move, the country’s central bank (BCRA) has been forced to hike rates by almost 1,300 basis points to 40 per cent.
This was in an effort to restore stability to the rapidly depreciating peso and help cool soaring inflation expectations.
Paul Greer, assistant fixed income portfolio manager at Fidelity International, said all these measures may not be enough to stave off the country’s problems, however.
“Despite now offering the highest nominal and real interest rates on the planet, as well as reducing their fiscal deficit target, it is still not certain the BCRA’s proactive response will achieve its near-term objectives,” he said.
Performance of indices over YTD
Source: FE Analytics
The MSCI Argentina index has fallen by 25.41 per cent so far this year. In comparison the MSCI Emerging Markets index (which the country is not a constituent of), is up by 3 basis points, as the above chart shows.
The country is the largest constituent of the MSCI Frontier Markets index at 21.94 per cent, which has fallen by 2.29 per cent for the year so far.
“The markets have seemingly lost patience with the authorities’ ability to manage the country’s ugly macro mix of widening twin deficits and elevated inflation,” Greer added.
“Of course, volatility in Argentina’s markets is not unusual and seasoned emerging markets watchers will be familiar with bouts of investor panic and currency depreciation during previous cycles.”
He said that the recent turmoil has been partly caused by the recent strength in the US dollar, which began in mid-April.
“The prevailing wisdom in foreign exchange markets since last summer has been of the US twin deficits and trade protectionism pointing towards a secular decline in the dollar,” Greer said.
“However, with 10-year US Treasury yields recently touching 3 per cent, investors have refocused on interest rate differentials and positioning,” the Fidelity manager said.
“These two factors have been largely ignored for the last six months but both remain heavily in the dollar’s favour, even after its recent rally.”
As such, he said the dollar is now set for further gains which combined with the Federal Reserve’s policy tightening schedule, cooling global growth momentum and challenging seasonal factors for risk markets has caused emerging market currencies to come under heavy pressure.
William Jackson, senior emerging markets analyst at Capital Economics, said a key factor has been the lack of apparent foreign exchange reserves, which has forced the country to seek aid from the International Monetary Fund (IMF).
“Argentina’s currency crisis and turn to the IMF for financial support have raised questions about how much ammunition emerging markets’ foreign exchange reserves provide,” he said.
This is despite Argentina’s foreign exchange reserves rising to a record high in dollar terms making them appear sufficient.
Instead of using the widely-used indicator of FX reserve adequacy of how many months of imports they cover, Jackson uses the sum of a country’s current account deficit and the amount of external debt that is due to mature within the next 12 months.
By this measure, he said Argentina, Venezuela, Turkey and Ukraine have the least reasonable reserves globally.
“In the case of Argentina and Turkey, gross external financing requirements are larger than foreign exchange reserves,” he said. “This is at the root of Argentina’s recent problems but also casts light on the recent fall in the Turkish lira.”
In Turkey, he said the expectation is that the central bank will tighten policy further over the coming months but that this may not be enough.
“And it’s not inconceivable that Turkey could ultimately be forced to follow in the footsteps of Argentina and return to the IMF if the central bank falls (further) behind the curve and market confidence evaporates,” said Jackson.
Performance of index over YTD
Source: FE Analytics
So far this year, Turkey, an MSCI Emerging Market index constituent, has performed similarly to Argentina with the MSCI Turkey index falling by 24.41 per cent.
With Venezuela, the collapse of its economy is only one part of the South American country’s problems, the analyst said.
“The path to sustainability lies in tighter fiscal and monetary policies and a weaker currency, backstopped by an IMF programme,” Jackson said.
“But it goes without saying that this won’t happen under the current government. Elections due this Sunday may add to the gloom.”
Others worth keeping an eye on are South Africa, Romania and Chile, the analyst added, as while an immediate crisis appears unlikely, fiscal policy will need to tighten in all three countries over the coming years.
Moving to the fixed income side, Fidelity’s Greer said the emerging markets are not immune to exogenous shocks particularly against a backdrop of rising US funding costs, global trade disputes and expensive valuations.
“Moreover, sharp fiscal deterioration in bellwether countries such China and Brazil, combined with election uncertainties across emerging markets over the coming months, clouds the picture further,” he noted.
One way for investors to look for protection is through domestic inflation-linked debt, notably in countries such as Brazil and Russia where nominal yields have compressed enormously in recent years.
However, it ultimately all comes back to the US dollar as the asset class historically underperforms when the greenback is strengthening.
Performance of dollar vs sterling over YTD
Source: FE Analytics
“Argentina’s experience over the past two weeks acts as a cautionary tale for investors positioned in overpopulated markets with vulnerable fundamentals. Given our expectations of further US dollar appreciation in the near-term, we don’t think it will be the last,” he said.