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Price Point - In Brief

Emerging Markets

Investing in Troubled Countries

Michael J. Conelius, Portfolio Manager, Emerging Markets Bond Strategy
Andrew Keirle, Portfolio Manager, Emerging Local Markets Bond Strategy
Samy Muaddi, Portfolio Manager, Emerging Markets Corporate Bond Strategy

Executive Summary

  • Volatility in emerging markets (EMs) such as Turkey and Argentina, which rely heavily on foreign capital flows, is to be expected when global conditions shift.
  • There are typically three broad investment stages to a crisis: the liquidity vacuum, the transition “from terrible to bad,” and the return to fundamentals.
  • One of the best times to be a contrarian is when market dislocations happen and managers can use their credit skills to differentiate between the casualties and the survivors.

It’s a familiar story for EM investors: shifting global conditions catch out a few of the most vulnerable economies, prompting currency crises and sharp falls in asset prices. This year, Turkey and Argentina have been in the spotlight as dollar strength and buoyant U.S. growth expectations have prompted investors to reassess the risk/return balance in EMs. Market dislocations are an important testing ground for active security selection, with potentially outsized rewards for getting it right but high penalties for getting it wrong. So how should investors approach these (and other) troubled markets?

The local circumstances are different but the outcomes similar. Turkey’s problem was one of “borrowed growth”: Aggressive domestic growth policies led to surging household and corporate borrowing in recent years, largely from foreign lenders. Once international confidence evaporated, the lira plummeted, losing around a quarter of its value against the dollar in August. This pushed up import prices and forced the authorities to respond to the growing inflationary threat.

Argentina, meanwhile, was widely seen as a financial market darling whose leaders were applying orthodox economic policies to address decades of mismanagement of government finances. But rising U.S. interest rates and some high-profile policy mistakes shattered investor confidence, and the peso’s decline accelerated sharply, prompting the central bank to raise rates to 60%.

Why did the situation in these countries unravel so fast? It’s not uncommon in EM debt that, when sentiment turns, a couple of countries get disproportionately punished. This can have as much to do with liquidity as it does with fundamentals. When sentiment changes and outflows happen, the exit door is quite narrow.

For example, the 10th of August saw the Turkish lira lose as much as 23% against the U.S. dollar in intraday trading. The Argentine peso suffered double-digit losses on the 29th and 30th before the central bank raised rates by an astonishing 15%. On those days, the currency market (typically the most liquid asset class) was essentially broken for extended periods of time. Our traders reported that brokers were unwilling or unable to quote a price in either currency against the dollar.

There were technical aspects to the selloff as well. For example, in the case of Argentina, because so many investors were already long, there was little room for incremental buying into the weakness.

Opening Quote But while these unusual conditions in the U.S. persist, they are forcing uncomfortable but necessary changes on emerging economies around the world that should, in the long run, help to make emerging markets more resilient. Closing Quote

INVESTMENT STAGES OF A CRISIS

One of the best times to be a contrarian is when market dislocations happen and active managers can use their credit skills to differentiate between the survivors and the casualties. Experience in previous EM debt crises shows that, while it can take years for a country’s economic fundamentals to turn around, the recovery in asset prices tends to happen much faster: often within three to six months of a crisis. Timing and an ability to look through the volatility and poor investor sentiment are therefore vital. Those who have not already done their research may be forced to choose between staying on the sidelines or taking a punt on assets they don’t fully understand. 

There are three stages of a crisis.  The first is a severe liquidity vacuum, which is where the most money can be made from yield. For example, in August, average spreads on Turkish hard currency corporate bonds blew out from under 500 basis points (bp) over U.S. Treasuries to over 1,200 bp, so contrarians stood to earn a hefty yield for taking exposure to Turkish assets. The J.P. Morgan CEMBI Turkey Index went on to return more than 20% between mid-August and the end of September.

We had been more bearish than the market on Turkey for some time, but felt that following the August spread widening, the fundamental risks were priced in. By mid-August, for example, we estimated that the entire Turkish banking sector was pricing in a bankruptcy scenario, so for our corporate bond strategy, we selected a couple of issuers that we had been covering on a long-term basis.

The second stage, where the greatest capital gains are to be made, is the transition “from terrible to bad.” As conditions ease, investors realize how short they are, and flows start coming back. Here, it often makes sense to retain exposure.

The third stage comes back to fundamental research and the long-term outlook for the country’s assets. As the market starts chasing the rally, the time comes to decide whether to stay in or move into countries that have a more positive policy stance.

FUTURE FUNDAMENTALS

One key question is whether the currency falls in Argentina and Turkey are having a measurable impact on the economic fundamentals. In Turkey’s case, we have started to see a response to the lira’s weakness: tighter credit conditions and slowing growth in external debt. There is still a lot of policy adjustment needed, but the rate of deterioration is slowing. In Argentina, the situation is still challenging as local investors, in particular, remain cautious.

The global conditions that underlie Turkey and Argentina’s difficulties are unusual—it is rare to simultaneously see expectations for higher interest rates and strong economic growth in the U.S. History suggests that either U.S. growth expectations will moderate or its strength will galvanize the global economy to catch up. But while these unusual conditions in the U.S. persist, they are forcing uncomfortable but necessary changes on emerging economies around the world that should, in the long run, help to make emerging markets more resilient.

Key Risks—The following risks are materially relevant to the strategies highlighted in this material: Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Returns can be more volatile than other, more developed, markets due to changes in market, political and economic conditions. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment.

Important Information
Unless otherwise indicated the source of all market data is J.P. Morgan Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2018, J.P. Morgan Chase & Co. All rights reserved.

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.

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© 2018 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

201810-634345

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