Click here for Michael Gomez's biography.

In an all too common occurrence of late, I found myself humming a Wiggles tune while driving home from the office recently. In case you are not familiar, “The Wiggles” is a group of four Aussies that has toddlers (and their parents) across the world singing and dancing. My family joined some friends and their kids for a Wiggles concert recently, and it was quite a show. One particular image of that day is ingrained in my mind: the whole crowd bouncing on one foot while pointing index fingers in the air (or “wiggling,” as it’s known) as the group performed the song after which this EM Watch is titled.

 

On that drive home, it occurred to me that the recent bout of volatility in financial markets also produced a lot of finger pointing. Market pundits, looking for the cause of all this stress, were “wiggling” at Chinese equities, the U.S. sub-prime mortgage market, UK-Iran tensions, the hollowing out of the U.S. manufacturing sector and CDO unwinds. But in a “twist” from the financial crises markets have experienced over the past decade there was one notable absence from this list of usual suspects: Emerging Markets’ fixed-income products, both external debt and local markets. In fact, EM external debt assets, which have been some of the most volatile financial instruments in past periods of market stress, were among the least volatile financial assets globally in March (Chart 1). What explains this twist from the past? Let’s point our fingers at some key factors that have served to stabilise EM even as developed markets gyrate.

 

Engine Number Two

A long-standing question posed at PIMCO is whether a second engine of global growth can emerge to take the baton and keep the global economy running should the U.S. consumer falter. For years we have looked at the prospects for both Europe and Japan and found little compelling evidence to suggest a dependable second engine there. So too has the emerging world traditionally been considered 1) not large enough to significantly alter the global growth picture, and 2) heavily dependent on U.S. growth prospects as a driver of its own growth story. But as the U.S. growth picture started to deteriorate significantly in Q1 2007, a number of investment houses began to cut projections for 2007 U.S. real GDP growth to the 2% area, while at the same time upgrading growth forecasts for China in 2007 to 10%, with risks to the forecast to the upside!

 

These projections are in line with the conclusions of PIMCO’s March Cyclical Forum where U.S. real GDP growth in 2007 was projected to come in below 2.25% and Chinese growth around 10%. Importantly, these projections
are not independent of one another, as China is expected to grow at 10% even as the U.S. stumbles on the back of housing and other woes. Low levels of leverage at the government level, heavy government planning and intervention in the economy, and still significant infrastructure needs leave plenty of room for internal stimulus in China should slower U.S. growth projections materialise.

 

After four consecutive years of double-digit real GDP growth, this forecast for China has widespread ramifications for global growth and global financial markets. China is now the world’s 4th largest economy measured in nominal GDP terms, and is expected to overtake Germany as the 3rd largest within the next two years¹. China is the number one importer of a host of agricultural and metals commodities (iron ore, aluminium ore, pulp and paper, soy beans, and cotton, to name a few) and it’s the world’s number three importer of oil (Chart 2).

 

Continued double-digit growth forecasts for China suggest commodities will remain relatively well supported, benefiting the commodity exporting economies. EM countries ran a $45 billion trade surplus with China in 2005, and are projected to run current account surpluses in aggregate for a 10th straight year in 2007². Hence, one reason for the lack of finger pointing at EM countries is that as China continues to grow, this source of demand for EM produced goods will continue to pull growth prospects for the rest of the emerging world along with it, U.S. slowdown or not.

 

External Debt: Here Today, Gone Tomorrow?

As EM external balance sheets continue to strengthen as links to China grow, pressure on EM currencies to appreciate relative to the U.S. dollar (USD) also grows. This pressure has been resisted in part through high degrees of FX currency intervention by EM central banks. And why not? A cheaper currency keeps EM exports competitive and at the same time the intervention has allowed many countries to build massive levels of international reserves that help signal to foreign pools of capital a level of financial stability previously unheard of in the EM universe. But when is enough, enough? Many EM countries are now showing signs of reaching bloated levels of USD reserves and are taking action to move away from the standard recycling of accumulated USD through the U.S. Treasury market. For some, like Russia, this takes the form of moving USD reserves to a basket including the EUR, GBP, Gold and JPY. For others, like China, this means setting up agencies to invest USD reserves more aggressively through strategic transactions (including targeting the acquisition of much needed natural resources) and broadening its investment universe to include a range of financial instruments outside of U.S. Treasuries. And finally for others, like Brazil and Mexico, the approach involves aggressively buying back external debt to eliminate the negative carry and currency mismatch vulnerabilities associated with these issues³. In fact, Brazil released a statement last month detailing $700 million of external debt repurchases made in secondary market transactions in January and February of this year. Credit Suisse estimated that in 2006, EM countries net retired $8 billion of external debt, and PIMCO expects that trend to continue in 2007 and beyond (Chart 3). So, a second reason for the lack of finger pointing at EM is that large, non-commercial agents were buying on any dips in EM external debt, even as the rest of the world flailed away in March’s wave of volatility.

 

Whither the U.S. Dollar

Paradoxically, as EM countries seek to mitigate USD weakness and prevent currency strength with the actions described above, the feedback mechanism is one that translates into even less demand for USD and more demand for emerging markets currencies from market participants as historical risk premiums associated with investing locally in these countries fall rapidly. As cycles mature and the financial markets play a repeated game, many countries gradually acquiesce to stronger FX levels as positive externalities become more obvious. These include a dampening of inflation pressure, more room for central banks to cut rates (thereby lowering government funding costs), and greater purchasing power for the citizens that these governments represent. These dynamics have manifest themselves in the market as investors recognise the firepower (in the form of international reserves) emerging countries have to ensure that their financial systems are insured from shocks, thereby dampening incentives for speculators to apply market pressure to EM foreign exchange rates. Furthermore, dislocations in local markets are therefore increasingly viewed as buying opportunities, anchored by strong fundamentals and policy frameworks (such as inflation targeting, independent Central Banks, and pension reform) that mirror developed country aspirations. These endogenous dynamics, coupled with a shaky foundation for the USD (including U.S. characteristics such as twin deficits, slower growth, lower interest rates, and a slow erosion of Bretton Woods II as reserves are diversified) make moving exposure out of the USD and into EM local currency attractive and provide a third reason for the lack of finger pointing at EM during the recent bout of volatility in other assets⁴.

 

Protectionism to Distract but not Derail

Seems like a great story, and it has been for investors in the asset class with 3 year returns for external debt of 10.4%, 9.9% for EM currencies and 14.6% for the long-duration EM local markets⁵. However, as we head into the U.S. presidential election cycle of 2008, protectionist sentiment is on the rise. The U.S. Commerce Department’s decision to apply countervailing duties against a non-market economy (namely China) for the first time in twenty years potentially could be expanded well beyond the coated paper industry currently targeted. Senators Graham and Schumer said recently they are drafting a new “veto-proof” bill aimed at forcing China to appreciate its currency more rapidly. Congress has indicated that approval of free-trade agreements negotiated with Colombia and Peru may be delayed pending further adjustments. And Senator Clinton’s recent vote against the Central American Free Trade Agreement and comments in a Time Magazine interview indicate that she may have broken with President Clinton’s push for free trade.

 

Understandably, these proposals come as increasing low-cost competition from around the globe frustrates the American worker. But enacting these protectionist measures will only serve to 1) shrink the pie of global growth, 2) raise prices on goods that come from abroad, disproportionately hurting the lowest income sectors of the U.S. economy who have benefited most from inexpensive products at places like Wal-Mart, 3) further deteriorate the U.S.’ standing in the international community as a leader of promoting free trade, 4) risk pushing developing economies that are embracing capitalism and free market orientation down a different path, and 5) further cement regional ties that are forming in places like Asia to counter long-standing U.S. economic dominance.

 

Will this be enough to derail the secular maturation of the emerging markets and lead to a new bout of finger pointing? We don’t think so. First of all, many policymakers in the developed and developing world are committed to avoiding the protectionist outcome. The points outlined above are important reasons why the U.S. has not more aggressively pursued protectionism despite the resurgence of this issue during the election season. And developing countries have tried to keep temperatures low, as illustrated by the relatively muted response of China’s authorities to the coated paper decision. Second, as mentioned previously, emerging markets themselves are providing an increasing source of homegrown demand, as credit markets develop and large infrastructure projects proceed in countries like China. Finally, there are the range of other fundamental improvements in emerging markets, including ever-improving access to capital, strengthened institutional commitment to market-based economic reform, quickening speed of information and technology transfers across borders, and the growing global muscle of multinational corporations based in emerging markets. These factors should help ensure that EM growth remains on a positive trajectory.

 

Bottom Line

In sum, we see three reasons for the lack of finger pointing at EM during the recent bout of volatility. First, growth in China should be able to sustain EM growth even in the face of a U.S. slowdown. Second, external debt buybacks by EM countries mean there are large, non-commercial buyers on any dips in EM debt. And third, the increasing attractiveness of EM currencies provides a source of demand for EM local debt.

 

How to invest with these trends in mind? Diversify your portfolio away from the USD and stop thinking of investing in EM as an alternative asset, but rather as a part of your portfolio allocation that may provide the best opportunities ahead. Our favourite investments include 1) positioning in Mexican local markets that price in interest rate hikes from the Bank of Mexico, while the U.S. curve prices in Fed cuts amid a dimmer outlook for U.S. growth⁶, 2) selectively capturing the additional premiums still charged by the market for EM corporate “market champions”, even as these companies are among the largest, most sophisticated and competitive in the world⁷, and 3) potentially benefiting from spread compression in core positions in Brazilian external debt and local markets as the credit continues its march to an investment grade rating.

 

There may be some more “wiggling” to come in global financial markets, but don’t expect to see those fingers pointing at the emerging markets anytime soon.

 

Michael Gomez

Executive Vice President

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¹  In PPP terms, the IMF estimates China is already the world’s second largest economy

²  IMF Direction of Trade Statistics, Bloomberg Financial Markets, and PIMCO calculations

³  Negative carry from investing accumulated international reserves at lower yields than a country pays on its own debt

4   For a review of Bretton Woods II, see the February 2005 Fed Focus “Conditionally Unconditional”

⁵   3 year total returns for the JP Morgan EMBIG, ELMI+ and GBI-EM Global Diversified as of March 30, 2007

^{6   See the September 2006 EM Watch “Is It Safe?”}

^{7   See the June 2006 EM Watch “The End of the Asset Class…Hardly”}