Emerging-Markets Selloffs: This One Is Different

By Christopher Whittall

The deepening selloff in emerging markets this year is one of the biggest of the past decade-and differs in ways that highlight how the developing world has changed.

The rout was triggered earlier this year by rising U.S. interest rates and trade tensions, concentrated in a cluster of countries highly dependent on dollar-denominated debt, particularly Argentina and Turkey. Other countries have been pressured but are less vulnerable because they rely less on foreign money.

Other changes to developing economies help explain this year’s extreme volatility. Whereas once banks were the dominant lenders to emerging markets, now asset managers are providing more money by buying up bonds and shares in these countries. That is important because it spreads the risks across lenders and funds. It could also herald wilder market swings, given investors can withdraw their money compared with what banks can do with loans.

Many investors expect further pain for developing economies, pointing to the jump in Treasury yields, a strengthening dollar and trade tensions.
The Wall Street Journal compared this year’s selloff with three others. In 2008, selling was kicked off by the financial crisis, in 2013 by a rise in Treasury yields and in 2015 by concerns over Chinese growth.
Returns dashboard

From a returns perspective, 2018 is among the most-severe episodes of the past 10 years.

But the selloff would have to deepen significantly to surpass the steep falls in equities and currencies during the financial crisis.

Across equity and currency markets, this year’s selling looks sharper than the so-called taper tantrum of 2013, when the belief that the Federal Reserve would trim its bond purchases pushed U.S. rates higher, hurting emerging-market debt. Losses in hard-currency bonds, or those denominated in foreign currencies such as dollars, were heavier compared with today. In 2018, those assets denominated in local currencies are faring worse.

Another crucial difference this time around is that a handful of countries are bearing a large part of the selling. This year, Turkey, Argentina and Venezuela have accounted for around 35% of the widening gap between emerging-market bond yields and Treasurys, according to Bhanu Baweja, deputy head of global macro strategy at UBS.

“In mainstream emerging markets, there are very few countries that are on the precipice of a crisis. That’s down to one very simple thing: You don’t have massive external debt,” said Mr. Baweja.

Capital Flows

Emerging economies’ reliance on foreign money has diminished compared with a decade ago. In 2017, overseas capital flows to emerging markets equaled 4.35% of gross domestic product compared with almost 9% in 2007, according to the Institute of International Finance. That makes these economies less vulnerable to a withdrawal of foreign cash.

Turkey, one of the countries investors are most worried about, has foreign debts that the IMF calculates at around 53% of GDP in 2017. “Emerging markets are much more robust right now in terms of foreign flows,” said Emre Tiftik, deputy director of global capital markets at the IIF. The source of the cash flowing into emerging markets has also changed. Asset managers buying up bonds and stocks now provide more cash to emerging economies than bank lending. Before the financial crisis, banks lent far more money.
That means losses from rising defaults in emerging markets will be shared by asset managers and the banking system. That reduces the chances of a systemic crisis, but could hurt pension pots. Also, bank loans tend to be longer term, while funds can usually move in and out of investments quickly, potentially leading to greater volatility.

The drop-off in foreign fund flows to emerging markets has been just as abrupt as during the taper tantrum, according to data from the IIF.

Like in 2013, flows were running at a high level before the start of the latest crisis. The rolling three-month average net flows came to over $40 billion in January, underscoring just how bullish investors had been coming into the year. The question now is whether those flows turn negative in the coming months, as in 2008 and 2015. If they do, that could presage further pain for emerging-market assets.