Since 2016, a narrowing of the Emerging Market (EM) vs Developed Market (DM) GDP growth differential underpinned a negative narrative for EM assets. Much of this owed to China’s deleveraging efforts but another part to headwinds resulting from the Fed’s tightening cycle. Both factors have now faded. China implemented policy stimulus that is now visible in some data while the Fed halted its tightening cycle and signaled a bias to stay on hold going forward. The upshot is that the EM vs DM growth differential will recover, providing a tailwind for EM Debt (EMD). This prospect is recognized by investors, as underscored by a record attendance at the recent IMF Spring Meetings. What impression did investors walk away with?
Selected Country Views:
China: Growing recovery confidence. China presentations focused on the country’s cyclical recovery and its expected deal with the US. There is generalized confidence that data is showing a bottoming of activity related to policy stimulus. There is even acceptance that the recovery ahead should be more muted than in previous stimulus led recoveries and appreciation that the new credit push comes at a cost for medium-term growth. Thus, investor expectations do not feel exuberant. Expectations about a deal with the US, however, are harder to gauge, in part because of fluid deal discussions. There is conviction that a deal will materialize, possibly within a month, as both sides have signaled willingness but there is concern that residual differences may remain intractable. The implication is that the deal may not be comprehensive nor lasting. Some issues are seen as resolved (e.g. US multi-year exports to China pickup, IP rights, technology transfer requirements, market access) but others are not (e.g. timeline and scope of tariff reductions, cyberwar agreement, technological development strategy). Amid this, trade experts worry most about a lack of an independent enforcement mechanism, hinting at the risk of unilateral agreement violation claims and a deal collapse down the road. For now though, China is seen as alleviating global growth concerns and thus supporting a more constructive backdrop for EM in coming quarters.
Brazil: Staying constructive through political noise. Investors are enthusiastic about Brazil’s ambitious economic transformation agenda. Social security reform is the well-known key reform and sentiment still sees the recent noisy debate in congress as a reflection of post-electoral political dynamics rather than a real threat to its passage. Tax simplification reform, privatization (already $12bn done YTD), public debt reduction and multi-year public payrolls cuts are other key agenda items being pushed more quietly in the background. Investor enthusiasm, however, is reflected in a generalized long position on Brazilian assets. Still, it is apparent that investors could go longer if they had certainty social security will pass in an acceptable form. Amid this, and facing reform and external uncertainties, the BCB is choosing to ignore dovish Brazilian growth and inflation trends. This hints at potential upside for front-end receivers ahead, especially if social security noise brings transitory higher local yields. The caveat is Brazilians in attendance seemed to already have on some form of receivers, underscoring the need to wait for better entry points.
Turkey: Shorts now the consensus view. Jammed packed meetings underscored strong investor interest in Turkey. An investor survey during the conferences identified Turkish assets as expected to be among the worst EM performers this year, consistent with other surveys pointing to an overall UW investor positioning. Turkish authorities’ presented a constructive view on structural reform plans and medium-run economic rebalancing. Investors’ questions, instead, were on implications of recent financial volatility and the fragile external liquidity situation. The authorities’ response was dismissive of these concerns, but also lacked a policy response to stabilize the situation. Together with political risks (e.g. threat of US sanctions if Turkey buys Russian missiles, risk of Istanbul election re-run), this hints that most investors are apt to hold on to underweights. However, being underweight is now a strong consensus trade and Turkish assets are already much cheaper. There is a risk of a short squeeze if President Erdogan decides to ease tensions with the US, acknowledge the election results, and/or reshuffle the cabinet to normalize policies.
Argentina: Focus on financial spillovers. Investor sentiment has again turned bearish. Part of this seems to be a reflection of recent negative price action that has been exacerbated by technicals. Another part has to do with the risk that wider yields may produce unstable debt dynamics, especially amid an uncertain and pivotal election in October. Argentina has achieved a major macroeconomic adjustment (e.g. twin deficits almost cut in half) and a strong funding program with the IMF. However an inflation peak is still pending, forcing very tight monetary policy, which is a key reason why Argentine assets are not reflecting positive achievements. The inflation peak is thought to be near with the end of public tariff hikes. Lower inflation would allow for lower yields, but the Argentine peso (ARS) trajectory amid electoral noise will be decisive for inflation. Conditions are now more favorable for ARS: the Treasury has a USD$15bn war chest to potentially defend the FX, the real effective exchange rate (REER) is no longer misaligned, dollarization is already historically high, and very tight monetary policy plus the income hit from recession limits USD demand. Investors acknowledge this but worry that the lengthy period until the election may prove destabilizing. The concern is heightened by the sense that investors generally did not reduce longs ahead of the recent selloff. As such, a rebound for Argentine assets does not look imminent.