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Only the brave drawn by emerging-market valuations amid myriad uncertainties


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Only the brave drawn by emerging-market valuations amid myriad uncertainties

Calling the bottom in emerging markets is a precarious occupation at the best of times.

Today, plotting a safe path through the sector involves weighing a raft of hard-to-know variables, including the passage of the coronavirus pandemic through countries with varying amounts of reliable data; a broad range of policy responses, both health and economic; the pace of reopening of developed economies; the extent of damage to commodity markets; investor tolerance of higher government debt levels; and the actions of multilateral lenders such as the International Monetary Fund.

Investors also cannot rely on the playbook from the financial crisis. In 2009, many commodity-dependent economies were hauled out of the mire by the Chinese government as a 4 trillion yuan spending package hoovered up metals, oil and food from around the world. These days, China is more watchful about its spending habits and has taken a measured approach to supporting its economy with fiscal stimulus.

For now, many investors are taking their money elsewhere.

The emerging market complex experienced its largest outflow on record in the first quarter of 2020. The Institute of International Finance high-frequency tracker revealed portfolio equity outflows of $72 billion and debt outflows of $25 billion, with investors initially exiting Asia in droves and then selling off elsewhere as the coronavirus outbreak spread.

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Currencies have been hit hard, particularly in commodity rich countries, despite the Federal Reserve being quick to offer U.S. dollar liquidity through swap lines to central banks. The facility allows global central banks to repo their treasury holdings in return for foreign exchange liquidity.

Brazil, a major supplier of soybeans, iron ore and oil, has the worst-performing emerging market currency so far this year, shedding 26.7% of its value as of April 24.

The other oil producing countries of Mexico, Colombia and Russia have suffered similar fates with devaluations of 23.2%, 18.2% and 16.4%, respectively, as the collapse in demand for oil outstripped cuts in production.

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The spread in yield between emerging market and U.S. investment grade debt surged from 146 percentage points on Feb. 20 to 303 by April 22, the highest since October 2011.

The opportunity for higher returns is already proving tempting to some investors.

"Valuations are very attractive," said Sergey Dergachev, emerging market debt manager at Union Investment, in an interview. "But over the next one-to-two months there will be a lot of volatility."

The IIF anticipates non-resident flows to rebound in the second half of the year, but forecasts the 2020 total to reach just $444 billion, less than half of 2019's $937 billion figure. Excluding China, the total is expected to be $304 billion, the lowest since 2004.

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However, emerging market investors will have to navigate an increased probability of defaults and the need for institutional support. The crisis has already claimed its first economic victims, with serial-defaulters Argentina and Ecuador both failing to make payments.

"We're going to see a very sharp fundamental deterioration in [emerging markets], we're going to see a pickup in default rates," Marcelo Assalin, head of emerging markets debt at William Blair, said in an interview. "What will mitigate this will be the support from multilateral organizations. The IMF has moved very aggressively and very quickly."

IMF support

The IMF has a $1 trillion lending capacity that can provide funds of up to $50 billion to emerging and developing economies and said it stands ready to step in to support ailing economies.

"I'm very confident they're going to use that," Assalin said. "Turkey and South Africa are candidates to go to the IMF. There is a strong resistance but both countries, especially Turkey, are in a very weak external position."

Moody's Investors Service downgraded South Africa’s local-currency rating to sub-investment grade March 27, voicing concern about the country's deteriorating public finances.

South Africa ran a fiscal deficit of 6.6% in 2019 that is expected to rise to 11.5% in 2020, according to rating agency Fitch.

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"I do not look optimistically at South Africa at all," Dergachev said. "It's the hot spot for coronavirus in Africa. Then obviously you have the problem with huge unemployment and migration problem. South Africa still has a big governance problem."

There are also big question marks over Turkey once again. The world's 19th largest economy has battled with fiscal deficits and inflation in recent years and the Turkish central bank delved deeply into its foreign exchange reserves in March in an effort to defend its currency, spending 23.1% of its total reserves, according to the IIF.

"We estimate that the Türkiye Cumhuriyet Merkez Bankası AS will completely exhaust net international reserves this week," Cristian Maggio, head of emerging markets strategy at TD Securities, wrote in a research note. "The [central bank] can still use gross reserves and gold. Given the current trend, we estimate that total reserves will be depleted at the latest by the third week of September, at the earliest by the third week of July."

Despite these challenges, the IMF projects emerging market and developing economies will, on average, experience a shallower decline and quicker upturn than in advanced economies. Emerging markets will see their economies contract 1% in 2020 before rebounding by 6.6% in 2021, compared with negative 6.1% and 4.5%, respectively, for developed markets, the IMF said in its economic outlook published April 14.

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"We have some exposure to Argentina, Lebanon, Ecuador because we believe in the ultimate recovery," said William Blair's Assalin. "We don't like Oman and Iraq because they have strong vulnerabilities and we are underweight Saudi Arabia, again on the oil story."

The prospect of an economic recovery and an accommodative IMF makes Argentina and Ecuador attractive, he said.

Union Investment's Dergachev also sees opportunities.

"I think there is a strong case for [emerging market] sovereign debt at this point because technical factors have turned the corner," he said.