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The news just gets worse for some emerging markets, with the collapse in oil prices adding further pressure to currencies and the fiscal situation of countries like Mexico, Brazil, and Russia. Of the commodity-producing emerging market countries, the one that is worrying analysts the most is Mexico.
Emerging markets outside of China had outflows in March that surpassed those during the global financial crisis as investors fled riskier assets amid the uncertainty created by the Covid-19 pandemic. Currencies have tumbled, with the Brazilian real down 32% versus the dollar so far this year, the Russian ruble down 19%, and the Mexican peso off 29%. That put pressure on many emerging markets, which were already struggling with sluggish growth, rising debt levels, and limited health resources and fiscal room to contend with Covid-19.
The need for fiscal stimulus significantly strained government balance sheets, leading to what Bank of America global economist Aditya Bhave described in a note to clients as “unthinkable” widening in fiscal deficits.
Many crisis watchers have closely been watching emerging markets because of the debt the countries have built up gorging on relatively cheap credit. As currencies decline, countries are finding it harder to finance and service that external debt at a time they need to spend money to alleviate the fallout from the pandemic. Highlighting the strain, the International Monetary Fund said last week that 102 countries had asked for or inquired about assistance from the lender of last resort. In a note to clients on Tuesday, Wolfe Research’s Chris Senyek highlighted emerging market debt as topping the list of credit concerns where the Federal Reserve has limited ability to intervene to help the situation.
Among emerging markets, Senyek said he was most concerned about Mexico, citing the sharp decline in the peso, the impact from the drop in oil prices, and a possible backdraft from the economic recession in the U.S., its major trading partner.
Emerging market currencies have fallen around 20% in some cases—typically an inflationary development. But low demand and the sharp drop in oil prices are disinflationary, giving emerging market central bankers room to cut rates to record lows, Jon Harrison, managing director of emerging markets macro strategy at TS Lombard, says in an email. For now, slow growth and rising fiscal deficits means a deterioration in debt to GDP dynamics, with weaker currencies exacerbating the risk. And on this front, Mexico is among the worst-placed, Harrison says. He expects GDP growth to contract by as much as 12% this year.
Mexico is a source of worry for others as well. Portfolio outflows in the first half of April from emerging markets appear to have slowed and other sources of capital, like foreign direct investment and banking sector flows, seem to be more resilient, with one exception: Mexican sovereign debt, according to Edward Glossop, emerging markets economist at Capital Economics. The government’s “lackluster response” to the crisis and fears that state-run oil firm Pemex could default could be hitting appetite for Mexican assets, Glossop writes in a note to clients.
For investors assessing opportunities, it is crucial to go beyond painting emerging markets with a broad brush. The collapse in oil prices, for example, is good news for oil importers like India and China. And even the outlook among hard-hit commodity producers isn’t clear-cut. The Brazilian real will likely stay under pressure, with outflows likely to continue as the country’s debt to GDP situation worsens and already struggling states like Rio de Janeiro see lower royalties as oil prices tumble, says TS Lombard Brazil economist Wilson Ferrarezi in an email. But there is a glimmer of good news: A weak currency makes Brazil’s agricultural exports that much more competitive.
More broadly, given the stress and the tightening in global financial conditions increasing the cost of funding deficits, emerging market central banks could move toward quantitative easing, developed market style. There are major differences: Developed markets took on quantitative easing only after hitting the lower bound on interest rates whereas emerging markets have started even though policy rates are significantly above zero, writes BofA’s Bhave, who describes the risks for emerging markets as “skewed to the downside” from this foray into quantitative easing.
Among the worst-case risks: Markets could lose faith in emerging markets as an asset class, Bhave writes. The flip side? There could be safety in numbers with so many emerging markets jumping on the QE bandwagon. A global reach-for-yield by investors, Bhave says, could lower emerging market yields without major currency losses, creating a favorable backdrop for EM economies.
Ashmore Group’s head of research Jan Dehn also sees eventual demand from yield-starved investors. “The single most important turning point for global FX will be the onset of U.S. recession,” Dehn says via email. The first-phase of this transition is the panic stage—what Dehn describes as happening now—as investors load up on dollars. Dehn expects that to be followed by a longer-lasting decline in the dollar and the start of a period when yield-hungry investors flock to local emerging market assets.
The iShares MSCI Emerging Markets ETF is down 19% so far this year, and the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) is down 14%. Cheaper valuations and higher yields could drive investors back to emerging markets once the dust settles, but it is unclear when that will be—and how some of the more fiscally vulnerable countries will fare in the interim.
