Bretton Woods Committee | Mon, Nov 21, 2022
by Gary Kleiman
Emerging market asset managers are eager to put this year behind them after double-digit stock and bond index losses and net outflows from their funds. Core and frontier equities though October were down 30%, external sovereign/corporate and local government bonds from 15% to 25%, and currencies, not quite as battered as developed market counterparts by the almighty dollar, off 10%. Mutual fund and ETF tracking was -$85 billion for fixed income and barely positive for equities, and the dozen economy central banks that regularly monitor foreign portfolio movement had respective outflows in the categories of $15 and $55 billion. In asset classes primary bond issuance is at multi-year lows and heavily skewed to investment-grade rated names, and P/E ratios at 10x future earnings, a decade bottom and historic discount. Only two major currencies, Brazil’s real and Mexico’s peso, are up against the dollar this year.
While the performance litany is uniformly gloomy, it masks a transformative period that sets the stage for healthier results and a reordering of basic economic, geopolitical and market development criteria in 2023 and beyond. The allocation decision shifts have simmered beneath the surface since 2008’s last global financial crisis test, and briefly erupted during the Fed taper tantrum a decade ago and China’s shock currency devaluation five years back. Revisiting and reinforcing these two fronts, higher interest rates en route to turning positive after inflation are here to stay, and maximum Chinese 5% GDP growth and benchmark index diversification from exposure are future norms. US central bank monetary and Beijing domestic stimulus and export powerhouse policies will remain a decisive influence but in a fresh context, as emerging markets again become masters of their own fate with separate initiatives, including revival of structural reforms through another wave of International Monetary Fund rescues.
Sub 5% growth and above 5% inflation now apply to the general universe, and fiscal and monetary tightening are in contrast with the post-covid approach. The global energy cost spike due to industry conditions and the Russia-Ukraine war has underscored the limits of budget support through subsidies and special transfers, as almost all countries run sizeable deficits. Government debt/GDP is 60% and corporate liabilities add another 100% for danger triggers. With the exception of Turkey and other outliers like Angola, no central bank is lowering benchmark rates as the mode is toward hiking, with Brazil’s currency and financial markets standing out as leaders in reward for early action and the highest rates after inflation.
The external accounts also reflect a new balance, with a more equal split between current account deficit and surplus countries especially in Asia where export and remittance flows are traditionally brimming. India, the Philippines and Thailand show gaps that in turn have weakened currencies and spurred central bank intervention. The turnaround in exchange rate management is a departure from excess FX reserve accumulation, and resurrected debate over capital controls now endorsed by the International Monetary Fund as a temporary crisis measure. While they have not been imposed outright, state-owned banks and pension funds are under orders to provide market support in a soft-touch version that has not been as visible since the late 1990s Asian financial crisis. With supply chains and tourism still constricted goods and services trade has sputtered, and portfolio inflows have been in a secular downswing particularly in local debt markets, where the foreign share of the total has halved on average across the asset class to 20%.
The Russia-Ukraine tragedy has distilled overarching issues not only of war and peace, but climate security, mass migration, and global governance in a real world brutal application of ESG screening. The Middle East and Africa have longstanding energy and post-colonial ties that preserve pro-Moscow sentiment as reflected in their UN vote stands. The risk of a nuclear accident in Europe’s largest plant under Russian troop occupation, and the destruction of one-fifth of Ukraine’s renewable energy sources in initial bombing are environmental debacles. In eight months of war 8 million have fled to frontline states and elsewhere in Europe, the largest displacement on UN record beyond Syria and Venezuela accumulated over years. Internally around that number are also on the move without the ability to decisively track. Poland and the Czech Republic each host over one million, with only a small minority intending to return home soon. They have already exhausted initial budgets, and housing is scarce or too expensive also for citizens stoking inflation and popular anger.
Egypt, Pakistan, and Sri Lanka have experienced local and external debt troubles for repeat IMF loan resort, and two breakthrough aspects have been overlooked early in package rollout. All three have committed to privatization of army/state-owned banks and enterprises that has barely occurred since a wave in the pioneer era of emerging market investing a generation ago, and they no longer have the fiscal or competitive wiggle room to delay. By the same token, exchange rate flexibility is pledged, after longstanding de facto pegs where the central bank maintains a target range. This arrangement went out of fashion in the mainstream as floating was preferred, and toward mid-decade today’s disgruntled fund managers can take solace in a fresh chapter for currency and across-the-board analytical regime change. They will look at China and the Fed, domestic and external economic and ESG indicators through an updated prism cultivating index and theme advantage.