08 May 2018, 14:55 GMT
Turmoil in Argentina
Argentina’s financial markets have experienced a tumultuous fortnight. The Central Bank (BCRA) has been forced to hike policy rates by almost +1,300 basis points to 40 per cent in an effort to restore some stability to the rapidly depreciating peso and help cool soaring inflation expectations. Despite now offering the highest nominal and real interest rates on the planet, as well as reducing their fiscal deficit target, it is still not certain the BCRA’s proactive response will achieve its near-term objectives.
The markets have seemingly lost patience with the authorities’ ability to manage the country’s ugly macro mix of widening twin deficits and elevated inflation. Of course, volatility in Argentina’s markets is not unusual and seasoned emerging markets (EM) watchers will be familiar with bouts of investor panic and currency depreciation during previous cycles.
Beware the strengthening dollar
To our minds, last week’s events in Buenos Aires link neatly back to the recent surge in the US dollar which began in mid-April. The prevailing wisdom in foreign exchange markets since last summer has been of the US twin deficits and trade protectionism pointing towards a secular decline in the dollar. However, with 10-year US treasury yields recently touching 3 per cent, investors have refocused on interest rate differentials and positioning. These two factors have been largely ignored for the last six months but both remain heavily in the dollar’s favour, even after its recent rally.
We feel the dollar has crossed the Rubicon in recent weeks and is now set for further gains. The dollar’s renaissance, combined with the Fed on policy tightening autopilot, cooling global growth momentum and challenging seasonals for risk markets have driven an investor retreat from EM with currencies under heavy pressure and credit spreads widening.
Not the last cautionary tale
The narrative in our asset class for much of the last two years has been robust growth, low inflation, improved balance of payments, rising commodities and generous real yields. We don’t disagree that EM’s macro fundamentals in aggregate are in a better place today compared to five years ago. However, EM is not immune to exogenous shocks particularly against a backdrop of rising US funding costs, global trade disputes and expensive valuations. Moreover, sharp fiscal deterioration in bellwether countries such as China and Brazil, combined with election uncertainties across EM over the coming months, clouds the picture further.
One area dedicated EM debt investors can protect themselves from the risks of a dollar revival is in domestic inflation-linked debt, notably in countries such as Brazil and Russia where nominal yields have compressed enormously in recent years. Bondholders still benefit from EM’s juicy real yields, but with inflation break evens historically cheap and EM currencies on the back foot, these instruments provide some defensive characteristics compared to nominal bonds.
Ultimately for EM debt however, it all comes back to the US dollar. Our asset class never trades well when the greenback is strengthening and recent price action illustrates how quickly sentiment can turn. Argentina’s experience over the past two weeks acts as a cautionary tale for EM investors positioned in overpopulated markets with vulnerable fundamentals. Given our expectations of further US dollar appreciation in the near-term, we don’t think it will be the last.
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