- Emerging market economies suffer from China slowdown and the escalating Sino-U.S. trade war.
- Elections and slow policy execution to inject volatility into emerging markets.
- Problematic state-owned enterprises add another source of risk.
Ripple effects from China
Almost all emerging markets (EM) are fairly dependent on the trajectory of China’s economy. We believe that doubts about the largest marginal buyer of almost all commodities, capital goods, and technology will slice the expected economic growth rates of EM countries. Concerns about a China slowdown could also be felt in unexpected places. Germany has an export-oriented economic model, and many of its products are sold to China. Yet, the fortunes of Hungary, Poland, and the Czech Republic are very tied to Germany — and thus indirectly to China.
“The China-U.S. trade war is likely to escalate and remain a risk in the foreseeable future.”
The China-U.S. trade war is likely to continue escalating and remain a risk in the foreseeable future. We expect the Trump administration to impose higher tariffs on a broader range of Chinese exports. Unlike many EM countries, China has the ability to implement stimulus policies, and we are beginning to see signs that China is increasing the scope of its stimulus by boosting infrastructure spending. However, policy error risk remains should the Chinese officials disappoint in the size and timing of these measures just as the rest of the world's economies are also slowing.
Elections and slow policy execution are a potential source of volatility
Turkey’s re-run of the race for mayor of Istanbul in late June and Argentina’s presidential elections in October both have the potential to rattle equity markets. In Turkey, should the ruling party prevail, we would expect to see widespread protests. If the opposition party wins, President Recep Erdogan could expand his authoritarian policies. In Argentina, the choice is clear: press ahead with difficult reforms under President Mauricio Macri or default and return to the dark days of former President Cristina Fernández de Kirchner.
These markets are not large enough alone to create extended volatility in the broader emerging markets unless other economic or political shocks are happening at the same time. Departing EM tourists, which are those investors who only invest opportunistically in emerging markets, could then cause dislocations in all EM asset classes.
Populists are running out of time
Mexico’s President Andrés Manuel López Obrador (also known as AMLO) and Brazil’s President Jair Bolsonaro were elected on left-wing and right-wing populist agendas, respectively. However, economic indicators have disappointed in both countries, and there has been scant progress in their ambitious economic plans. As a result, there is the real risk that investors and the local population will lose patience with both governments. AMLO has little room to maneuver because of slowing economic growth, financial stress at state oil company Petróleos Mexicanos (Pemex), and the market’s demand for fiscal discipline. The Federal Reserve’s pause in interest-rate hikes, which are now more likely to be cut, have given Brazil’s Bolsonaro time to pass the difficult pension reform, but the markets will not have infinite patience. These two countries are large enough to matter in the broader emerging markets.
Problems at state-owned enterprises
The financial difficulties at Pemex caused several ratings agencies to downgrade the company to junk status and Mexico’s sovereign debt rating to near junk. The need to recapitalize an energy monopoly in South Africa has also similarly threatened South Africa’s sovereign debt ratings. However, both countries are not the only ones with poorly run state-owned enterprises (SOEs) with the potential to generate unhelpful headlines. For example, problems at Chinese and Indian SOE banks have created meaningful contingent liabilities for their respective governments after years of doing national service.
These problems have also produced collateral damage to other segments of the economy. For example, how could investors favor Indian infrastructure, which needs leverage to grow, if 75% of the Indian banking system* is filled with underreported and sizeable non-performing assets? Very few companies can grow in a vacuum, and SOEs are generally an important part of emerging market economies.
Defensive portfolio positioning
We have started to reduce our very large underweight to China in anticipation of more aggressive stimulus measures, but we do not feel the need to jump into Chinese assets more aggressively at this point. We remain defensively positioned in the broader emerging markets portfolio.
*Source: Putnam, June 2019.
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