The Consequences of the Global Liquidity Crisis for Emerging Markets Investors
The short – but extremely eventful – history of the COVID-19 crisis began in emerging markets (EM). As the crisis expanded to encompass the globe, it has morphed from an exogenous shock affecting mostly EM, to an oil shock impacting risk assets including EM, to its current manifestation: a liquidity shock to global markets, resulting in substantial outflows and plunging prices in EM. Asian currencies and Asian equity and debt markets have collapsed,1 culminating in the closure of financial markets in the Philippines on March 17.
It will be some time before EM investors are able to align their decision making to fundamentals2. At this point, liquidity is the key factor to watch. To that end, this commentary will focus on the impact of the current liquidity shock on EM debt and equity markets.
Dependence on Liquidity and Flows
EM markets have seen a regime shift to what seem like end-of-cycle conditions in which liquidity, positioning, funding needs and fears of forced selling are front and center. Fund flows are an immediate area of focus. Many EM economies are running large current account deficits (see Figure 1) that they have compensated for through flows in capital accounts and foreign direct investment (FDI). FDI has been stable or declining in most EM countries, although lower oil prices have supported EM trade balances overall. Based on current account balances and FDI, South Africa, Chile, Colombia, and Indonesia are most in need of flows (see Figure 2).
Of course, the present inertia does not mean that emerging markets are free of fundamental challenges. Emerging markets’ potential for GDP and earnings growth are a serious concern. In addition, much-needed structural reforms are likely to be put on hold as EM countries focus their attention on combatting the outbreak.
For long-term investors in EM, the current crisis most closely resembles conditions during the 2008-09 Global Financial Crisis and the 2013 Taper Tantrum. When we compare current outflows with those crisis points, we are somewhere near halfway done – there is still room for more outflows.
EM economies’ dependence on flows and foreign direct investment therefore leaves EM assets vulnerable on a number of different fronts. EM countries have substantial short-term financing needs that have been jeopardized as EM markets experience heavy outflows. The liquidity squeeze in DM is further pressuring the full range of assets associated with the credit markets, including EM assets.
Takeaways for investors
During this crisis, EM assets (both debt and equities) have behaved like risk assets, rising and falling more or less in tandem with equity markets across the board. We believe this pattern is likely to continue as the DM liquidity shortage continues to pressure EM.
Various developments could come together to ease the liquidity shortage in EM. A liquidity injection from DM central banks would be helpful. Fiscal stimulus could also help to support fundamentals on a near-term basis. Ultimately, however, we believe the crisis will persist until a decrease in the rate of COVID-19 infection, particularly in the United States, begins to materialize, bringing with it increased stability in DM economies. Until then, markets are unlikely to trade on fundamentals, and liquidity will remain a crucial factor in EM markets – one that deserves close attention.
Even as EM markets face substantial challenges in the current crisis, we see potential for aggressive monetary and fiscal policy moves to support underlying fundamentals and for attractive bargains to emerge in EM securities. In the meantime, we encourage investors to bear in mind the costs of liquidation when liquidity is at a premium. For long term investors, we believe that EM assets will continue to be an important source of diversification and growth.
1For example, as a recent report by UBS points out, recent outflows in Asian equity markets have neutralized almost all 2019 inflows into the region, and have at this point exceeded the full-year outflows from the 2011 and 2015 EM equity sellofs, combined. (Source: EM: How Much Value Has Been Created in the Selloff? [UBS, 17 March 2020]). 2The swift course of events in this crisis limits the ability to forecast based on fundamentals. We see an example of this in the analyst community. As of February 29, 2020, over 50% of sell-side analyst estimates had not changed over the previous two months. Nearly 20% of the revisions anticipated improvement in earnings-per-share. (Source: State Street Global Advisors and Factset.)
Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Diversification does not ensure a profit or guarantee against loss.
Investing involves risk including the risk of loss of principal. The views expressed in this material are the views of Gaurav Mallik through the period ended March 24, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The targets and estimates are based on certain assumptions and there is no guarantee that the estimates will be achieved.
All information is from State Street Global Advisors unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The information provided does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.