Emerging markets: Why Wall Street is splitFebruary 19, 2014: 5:00 AM ET
Today's emerging economies are more diversified than in the past, and also less amenable to investment generalizations.
By Mohamed A. El-Erian
FORTUNE -- Established and highly regarded experts are quite divided on how investors should react to the recent volatility in emerging markets (EM). Some, like the famous EM equity fund manager Mark Mobius, expect the instability to continue and warn investors to be cautious and measured in adding exposure. Others, such as Jim O'Neil, the respected former head of Goldman Sachs Asset Management, believe that such concerns are overdone. They think investors should be exploiting now a huge buying opportunity.
I suspect that this unusually large divide among such experts reflects more than diverse interpretations of the same set of economic, financial, and technical data. It may also point to different underlying frameworks. By analyzing the contextual issues in greater detail, a third approach emerges -- one that recognizes the recurrence of bad old EM behaviors yet suggests a different mix of outcomes and implications.
The heightened volatility in EM assets has been going on for a while now; and it has been quite severe at times. The major selloff was triggered almost a year ago by concerns that the U.S. Federal Reserve would tighten monetary policy ( called "taper"), bruising badly every segment of EM -- both in absolute terms and particularly when compared to what has been happening to other asset classes. Indeed, when you look at the 2013 numbers, it is hard to recall such a large and broad-based dispersion in performance across equities, currencies, sovereign, and corporate bonds.
Three EM-specific factors aggravated the impact of relatively tighter global financial conditions: slowing growth in several emerging economies, concerns about policy incoherence in some of them, and technically vulnerable investor imbalances (particularly between the small group of "dedicated" investors who know the asset class relatively well and can withstand more readily volatility bouts, and "crossover" money susceptible to running out at the first sign of serious dislocations).
It is this mix of drivers that reminds many of the "bad old EM." No wonder contagion (whereby disruptions in weaker EM names contaminate stronger ones despite very different fundamentals) is no longer as a relic of the bad old EM days of the 1980s, 1990s, and early 2000s. It is now more appreciated as a current day reality given the series of highly correlated selloffs, with particularly sharp moves in currencies.
Many were caught offside by the change -- and not only investors who were unable to stomach the heightened volatility but also some companies that have scrambled to deal with their foreign currency exposures.
The next step of this EM dislocation will also seem very familiar to old-timers like me. Specifically, with some countries facing no choice but to hike interest rates and cut fiscal deficits, growth will slow even more, heightening the domestic risk of a negative feedback loop for those countries unable to reformulate promptly their policy mix. In the process, this may fuel preexisting social and political tensions, making it even harder for these governments to act decisively.
I suspect that it is only after this stage plays out that the script will evolve differently, reflecting some notable changes between today's emerging economies as a group and those of yesteryears. Indeed, it is important to recognize the following seven key differences:
- The average asset quality of EM sovereigns has improved markedly in the last ten years -- from Ba2/BB to Baa3/BBB (as measured by the widely followed EMBIG index);
- At just 35%, their combined public debt-to-GDP is considerably lower than before;
- The composition of debt is a lot better -- fewer short-term obligations and much lower currency mismatches;
- At $8 trillion, international reserve holdings provide considerable funding buffers;
- Most emerging economies have effectively exited rigid currency regimes that were particularly vulnerable to speculator attacks;
- Some of the systemically important emerging economies seem to have ready access to reactivated swap facilities at major western central banks; and
- At the corporate level, businesses are generally more resilient and better able to navigate financial volatility.
Of course, what is true for the asset class as a whole is not true for every country. Some like Argentina and Ukraine are particularly vulnerable as they also incorporate heightened political idiosyncratic risks -- a dimension that will be around for a while given the packed political calendar in several countries. Yet, as an asset class, EM is considerably less prone to the old threats of spreading serial defaults, sustained currency overshoots, and multiple tense IMF negotiations.
Notwithstanding their continued sensitivity to volatility bouts, today's emerging economies constitute much less of a systemic financial threat than they did in the bad old days. Their degree of self-insurance is greater than what it was 10 years ago, and their financial structures are generally more robust. In addition, there has been extensive discussion of EM risks over a period of numerous months, making a systemic surprise event in financial markets less likely.
Having said that, and before we let ourselves slip into complacency, we should remember another important fact: Today's EM are a much bigger part of the global growth equation.
According to IMF data, EM's share in global GDP have increased from 20% to 38% in the last 10 years (and even more in PPP terms). Moreover, this group of countries has contributed almost two-thirds of real global GDP growth in the past 10 years at prevailing exchange rates.
Of course, no single country exemplifies the newfound systemic growth prominence of emerging markets more than China. China is now the world's second-largest economy, accounting for 12% of global GDP -- three times more than a decade ago. Indeed, for this reason alone, both investors and policymakers would be well-served to keep a close eye on China's efforts to control excessive domestic credit growth.
These days, the durable impact on the rest of the world of an EM disruption will operate much more through economic channels and less through financial ones. As such, it will end up being more nuanced. So, contrary to the natural desire to make bold predictions for the asset class as a whole, this is no longer a homogenous asset class. Instead, it is a collective of technically linked but economically quite diverse names; and it is an asset class that warrants a highly differentiated investment approach.
Mohamed A. El-Erian is the outgoing chief executive and co-chief investment officer of Pimco.