Summer is over (although the view from my window disagrees) and we are facing mounting global risks.
July and August have seen some spectacular moves in prices and markets. As recently as mid-August, the EURUSD was at 1.13 and ended the month testing 1.17. Emerging Market noise combined with Trump’s trade wars is certainly boosting volatility. Trump seems set to push ahead with a further $200bn in tariffs against Chinese goods. Enter stage left the Brexit harbinger of doom, having recently returned from its summer vacation, and we are set for another run on risk premiums.
The big EM question relates to the scale of EM developments. Are we looking at a full blown EM crisis or are these moves localized? Certainly the developments in Turkey and Argentina pose a very real risk of further EM contagion, but there are a number of arguments against the contagion reaching crisis levels. These include:
- Valuations in fixed income asset classes have largely priced in the bad news already, and continue to offer attractive investment yields.
- Strong global and company earnings continue unabated and should help to steady the ship.
- China’s interest rate cutting cycle should help support market liquidity.
- Fed hikes have likely peaked, or certainly market expectations regarding their quantum have peaked.
- EU bank exposure to Turkey is expected to be lower than initially estimated, with Spain and France carrying most of the risk. Both the French and Spanish banks are thought to be sufficiently capitalized.
Although, this does not mean we are in for a smooth ride.
Italian bonds are bearing the brunt of the contagion fears, with Italian benchmark 10 year yield spreads up at 291 bps over German bonds, closing Friday out at a five-year high. Italian bonds are second only to Greece in the euro area.
Turkey not wishing to disappoint, has got the ball rolling with a 2% sell-off in its currency this morning and is likely to set the tone for EM’s for the rest of this week. Inflation figures due today are likely to show an acceleration to 17.6% for August.
Brazil is facing its most uncertain elections in decades, with political pressureraised further by the electoral court banning the front runner, former President Luiz Inacio da Silva from participating in October’s elections. Brazil has a large fiscal budget deficit.
Argentina’s woes have left many of the market’s best-known investors wrong-footed, resulting in huge losses. The country raised interest rates to 60% last week in a desperate attempt to shore up its currency, the Peso. This case in particular highlights situations where currencies are seen as overvalued. Market forces are cruel, especially when conditions become self fulfilling. High foreign debt levels, coupled with high inflation, made Argentina one of the more vulnerable EM’s subject to selling by foreign investors.
Beware of the carry trade. Many EM’s have enjoyed continuous inflows into their bonds and equities since the financial crisis, with investors borrowing in low interest environments and investing in these high yielding assets. Rates are rising and the carry is unwinding. Countries like South Africa are particularly vulnerable, having transitioned from relatively low levels of foreign debt a decade ago to very high levels now. As has been illustrated in Argentina, currency devaluations ramp up the level of outstanding debt as a percentage of GDP and very soon the country is faced with the unpleasant dilemma of putting through a call to the IMF.
This week is data heavy, despite a shorter week in the US due to Labour Day today. Key releases include the US trade balance and employment report.
For more information, please contact Lionel Kruger, Director at JCRA, at Lionel.Kruger@jcrauk.com.