Changing macro and market backdrop for emerging markets
Emerging-market risks tend to be driven by various factors. We built a heat map to identify them.
It’s often a challenge to pinpoint the exact cause of emerging-market (EM) risk because risks tend to be driven by a range of factors.
Recent EM turbulence could be attributed to:
- The marked rise in both short- and long-term U.S. Treasury yields since tax cuts passed in late December
- A near-6% appreciation of the trade-weighted U.S. dollar since late January
- The medium-term trend of changes in the EM and developed-markets (DM) growth differential, which peaked at 4.5 percentage points in Q2 2010 and dropped to 1.5 percentage points in Q4 2017.
- Changes in the global cycle affecting the sentiment driving capital flows into/out of EMs.
The magnitude of the spillover effects from DM factors, such as U.S. monetary policy, onto EM assets often depends on the financial, economic and institutional structures of EM economies. To help spot where these risks might be, we consult our EM heat map. It’s a systematic assessment of EM vulnerabilities that are typically associated with crisis episodes. This is within the context of recent pressures on EM assets, as well as longer-term changes in imbalances. We are able to use the heat map to find significant pockets of vulnerability in certain economies.
Emerging markets heat map
Source: Aberdeen Standard Investments, June 2018.
According to our framework, Argentina, Chile, Colombia and Ukraine display the greatest aggregate risks, though Egypt, Israel, Poland, South Africa, Turkey and Malaysia have significant cyclical imbalances that leave them relatively more vulnerable to a change in the global economic and financial environment.
Despite these challenges, the aggregate EM picture is more encouraging now than in Q2 2017, and considerably more so than in 2013. As a result, we consider a systemic EM-wide crisis to be a relatively low-probability prospect. A strong or improving macroeconomic and market backdrop can also be supportive for EM equities.
To identify risks and subsequent opportunities using the heat map, we focus on five dimensions of EM risk:
- External imbalances
- Domestic private-sector imbalances
- Public-sector solvency
- Institutional policy frameworks
- International exposure
These have, on different occasions, been the epicenter of major crises. We measure risk from a cyclical, structural and aggregate perspective. On the cyclical front, we look at variables that change quickly from quarter to quarter. On the structural front, we look at the degree to which countries would be exposed to shocks of a specific structural form, such as a snowballing of protectionism. Structural factors, and in particular the soundness of domestic economic and political institutions, can also interact with cyclical factors either to amplify or dampen the effect of shocks, and therefore, impact companies in the region.
Pockets of cyclical risk
Starting with the external sector, a key measure is economies’ basic balance – the current account balance plus net foreign direct investment (FDI), as a share of gross domestic product (GDP). The basic balance is a measure of the extent to which the current account is financed by short-term portfolio flows and bank lending, which may dry up during a stress period.
Since 2017, the basic balance has improved slightly in Chile and Colombia, but worsened in Israel, Russia, Turkey and Ukraine. Israel has seen its current account surplus modestly shrink.
FDI flows have recently turned negative. Countries such as Argentina and Egypt have been running consistently wide current account deficits. Overall, external financing needs are particularly high in South Africa, Turkey, Argentina, the Philippines and Egypt. South Africa and Egypt have also relied on substantial non-FDI inflows over a five-year horizon.
Economies signaled as risky on this metric are China, Turkey and the Philippines. Corporate leverage is high in Brazil, Ukraine and China, while high and rising house price-to-income ratios are on the risky side in Argentina, Chile, Peru, Israel, Malaysia and the Philippines.
Economies signaled as risky on this metric are China, Turkey and the Philippines.
China had the worst score in our cyclical risk category, primarily due to the rapid rise in debt over the past five years and high levels of corporate leverage. While China’s domestic imbalances will constrain future growth, we do not view them as risking an imminent crisis.
To asses EM economies’ structural exposure to the trade and financial spillovers of U.S. monetary policy, we look at trade as a share of GDP, capital account openness and correlation with the U.S. business cycle.
We would expect countries with a large trading sector and open capital accounts to be more highly correlated with the U.S. business cycle. On this basis, the countries we have identified with high U.S. exposure include:
- The Czech Republic
We also account for possible risks from a slowdown in Chinese demand for imports. Countries with a high share of commodities in their merchandise exports may stand to lose from a Chinese slowdown. Peru, Venezuela and Chile are highly exposed to this risk.
Federal Reserve Chair Jerome Powell noted in May 2018 that EM economies are better positioned to deal with increasing U.S. interest rates because of improvements in their institutional policy frameworks. That interpretation is broadly justified by our EM heat map.
Where the greatest risks are
Latin America seemed to be the region where countries had the highest risk scores, according to our research. Emerging Europe was fairly homogenous in terms of moderate risk scores, with the exception of Ukraine. Emerging Asia showed the most variation. In terms of specific countries, overall risk was highest in Argentina, Chile, Colombia and Ukraine.
Risk scores for previous quarters have been driven by changing fundamental variables. Looking forward, we expect that the evolving external environment will put pressure on certain economies, and the pressure points we have highlighted are worth watching.
While it’s clear risks remain, the opportunities are also there. With proper diversification, investors can take advantage of future growth across EM.
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.
Image credit: Mario Tama / Getty Images
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