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Investors typically seek out emerging market investments for the prospect of higher returns, but this is often accompanied by greater risk. Foord Singapore portfolio manager GUY SHIRTLIFF takes a closer look at the emerging turmoil in emerging markets.

The development of emerging market economies is seldom smooth and often plagued by political instability, corruption, infrastructure bottlenecks and currency volatility. Investors consequently demand much higher returns than those available in developed markets to compensate for these uncertainties. In periods of crisis or liquidity tightness, the required returns rise further, forcing down asset prices.

The unprecedented central bank stimulus unleashed after the 2008/2009 global financial crisis suppressed global yields and drove up asset prices. The liquidity pumped into the global system was needed to stabilise market turmoil but had unintended consequences. Low-risk investors such as the burgeoning pensioner population, were pushed down the risk curve into riskier assets such as equities and emerging market investments.

The flood of new money allowed emerging markets’ governments to fund their development aspirations and cover deep budget deficits for a decade. But unfortunately for emerging markets, the trend is starting to reverse. US Federal Reserve monetary policy is now more hawkish, favouring higher interest rates and stimulus withdrawal. As the federal funds rate rises, so does the attractiveness of investing in US dollar cash and the hurdle rate for indebted emerging economies. It is no coincidence that recent emerging market woes are strongly correlated with US policy tightening. 

Twin deficit nations, running trade and budget deficits, are in the vanguard. Debt-to-GDP ratios and the cost of funding future deficits are rising sharply in these markets as investors demand a greater risk premium for growing default risk. Argentina and Turkey are prime examples of the downward spiral of lost investor confidence and their currencies have now plunged against the US dollar. Emerging market contagion risk has spread to other vulnerable twin deficit nations such as South Africa, Brazil and Indonesia.

Trump’s antagonistic America First policy and disruption of the liberal world order is compounding emerging market anxiety. Sanctions, trade wars and rising oil prices detract from much needed global growth. And a global growth shock would be disastrous for countries with stretched national balance sheets. These fears are now beginning to manifest in troubled emerging markets faced with much higher financing costs.

China is the world’s second largest economy and is the largest emerging market. President Xi’s ambition to establish China as a global superpower offers hope by suggesting that China could fill the leadership void left by a retreating US. But for now, China’s own debt issues and prospects of a prolonged economic war with the US mean it is not immune to recent emerging market sentiment.