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.
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.
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.
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.
This commentary is provided for informational purposes only and should not be construed as investment advice. The opinions or forecasts contained herein reflect the subjective judgments and assumptions of the investment professional and do not necessarily reflect the views of Barings, LLC, or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.