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2020: An Inflection Point for EM Currencies?

2019 December - 2 min read

With the financial crisis more than a decade behind us, the global financial system seems poised to begin re-leveraging. This process, which would likely take years to play out, would provide a source of funding for EM currencies, and represent a significant tailwind.

Biggest Risk

The biggest risk in 2020—meaning the one with the potential to have the largest negative impact on emerging markets (EM) and the broader global economy—would be a recession in China. While this is not our base case scenario, it is the risk that keeps us awake at night, simply because of all of the negative knock-on effects that could ripple through the global economy. In recent years, the Chinese government has taken strides to reduce leverage, which had been increasing steadily since the 2007/2008 global financial crisis. As we saw in the U.S. a decade ago, the process of deleveraging an economy is complex, as it can ultimately lead to a shortage of capital or credit—and a lack of liquidity—in financial markets. Ultimately, this can make it more difficult for issuers to meet their financial obligations, increasing the likelihood of defaults. If defaults in China were to become material and widespread, we would expect there to be fairly serious consequences for the global financial system.

While the ongoing trade tension between the U.S. and China does create some additional pressure, we don’t consider it to be a major, or unmanageable, threat to emerging markets. This is largely because China has been able to reallocate resources quite effectively in the past, and we have confidence that the country will continue to do so going forward. As we mentioned in a recent Q&A, the Chinese government has also managed the trade restrictions from the U.S. very successfully over the past year, and in our view is willing to tolerate the negative consequences of the trade tensions through 2020. The greater concern is a longer-term misstep in policy, particularly in the effort to deleverage the economy.
 

Biggest Opportunity

EM currencies represent the most compelling opportunity in 2020, and could drive strength in EM local debt and EM equities in the year ahead. The global economy has gone through a massive deleveraging exercise in the 11 years since the Global Financial Crisis (GFC). This has manifested itself in portfolio and banking flows moving out of riskier assets—emerging markets chief among them. Now, with the GFC more than a decade in the rear-view mirror, the global financial system seems poised to begin re-leveraging. This process, which would likely take years to play out, would provide a source of funding for EM currencies, and represent a significant tailwind.  

It’s important to highlight that most emerging markets, because they’ve faced outflows due to restrictions on their external accounts, have been running smaller and smaller current account deficits in aggregate—with some EMs now running current account surpluses. That means that the financial needs of EMs have continued to come down—or in other words, their balance sheets are in better shape. We believe that in 2020, this decade-old risk aversion may begin to turn, providing support for EM currencies to outperform, potentially driving strength in asset classes like EM local debt and EM equities.
 

ARE EM CURRENCIES POISED TO OUTPERFORM?
REAL EFFECTIVE EXCHANGE RATE/TERMS OF TRADE

Source: Haver Analytics; Barings. As of October 2019.

Bold Prediction

A bold prediction for 2020 is that the opportunity we’ve identified above—that EM currencies look cheap and that structural forces are in motion to potentially reverse their underperformance—actually begins to play out. In fairness, we cannot point to one clear catalyst in 2020 that will drive this reversal, but in surveying the global landscape for value, EM currencies stand out as a clear opportunity.

The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service.  The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research.

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In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate.

Unless otherwise mentioned, the views contained in this document are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice.  Parts of this document may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any forecasts in this document are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Any investment results, portfolio compositions and/or examples set forth in this document are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments.  The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this document.  No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments.

Investment involves risks. Past performance is not a guide to future performance. Investors should not only base on this document alone to make investment decision. 

This document is issued by Baring Asset Management (Asia) Limited.  It has not been reviewed by the Securities and Futures Commission of Hong Kong.

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