The changing world of emerging markets investing
At a basic level, accounting for the external factors influencing emerging market (EM) economies used to be a relatively straightforward task. If you kept an eye on Fed policy, US dollar trends and the IMF, you could go quite a long way to understanding the most important external variables for these economies. That is no longer the case.
For a long time EM investors have been only too aware that higher US interest rates and a stronger US dollar are typically bad news for EM debt investors because they imply tightening global liquidity and increased external debt servicing burdens in local currency terms.
Of the external factors impacting EM economies, geopolitics has been relatively calm for the last couple of decades and less important. That is changing and it requires a different skill set from investors.
The pre-eminence of the US as a global hegemon is under threat from the rise of China. The US in turn is seeing its international role in the world in narrower terms. President Trump is using more sanctions than his predecessors and opting for bilateralism over multilateralism.
This poses conceptual and practical challenges for investors. Conceptually, much of the way that investors think about global markets is premised on the pre-eminence of the US. At the most basic level, if that changes over time then investors’ assumptions about the role of the US will have to change too.
It will have an impact on the way we think about the institutions that control global governance too.
The IMF and World Bank still play a pivotal role in emerging markets and it is hard to see that changing any time soon.
But the Trump presidency has undermined the World Trade Organisation, which was essentially the poster child for US trade policy for decades. The IMF could also yet find itself caught up in the crossfire between Trump and China.
Sanctions are familiar to EM investors but what we have seen in the last two years is not.
In the past, sanctions generally came courtesy of the UN. They were reasonably predictable and focussed in nature.
By contrast, many of the US sanctions over the last two years have been hard to predict and have apparently unintended consequences.
When sanctions were imposed on Russian aluminium maker Rusal and its owner Oleg Deripaska in April it had a significant impact well beyond the company and individual. The entire global aluminium market, a vast swathe of Rusal’s suppliers in and outside Russia were severely affected and almost no one saw them coming.
This pattern of sanctions will continue this year. Predicting them will be hard given so much seems to hinge on Mr Trump’s him. But investors will need to try to understand their impact. That means a more detailed analysis of transmission mechanisms of sanctions, through mechanisms like supply chains.
Sanctions are not the only new external factor. The US-China trade war is having a fairly unequivocal and clear impact on the open economies of most EMs that are premised on open global trade.
Properly understanding the implications of the trade war will require much more analysis than just looking at the brinkmanship alone. Anything beyond the first order implications will take until well into 2019 to fully understand regardless of whether the trade war ratchets up or down in the short term.
The new era of geopolitics will also force investors to revisit past assumptions. The close correlation of the Russian ruble and oil has been disrupted this year by sanctions. Rusal sanctions in April sent the ruble down as oil held steady and then rallied as oil fell at the end of the year because anticipated new sanctions failed to materialise.
Yet more external factors could become relevant this year. Mr Trump’s threats to cut aid to some countries could yet turn into more than words. The impact for some countries would be slim. It would amount to around 0.4% of GDP in the case of El Salvador and Honduras and 0.2% of Guatemala’s GDP.
Such cuts are manageable but those proposed for Venezuela are not. Likewise, if Trump was to push back on IMF support for countries that have borrowed significant sums from China, as Secretary of State Pompeo has done with Pakistan, that will not bode well for a broad swathe of countries in Sub-Saharan Africa.
External risk factors are nothing new for EM investors. But what is different from the past is that the key driver of risk is the US, where the policy environment has become less predictable.
The impact from changing US policies could be far reaching, weakening the influence of multilateral institutions and the countries that are dependent on their support. The world is changing. EM investors need to too.