Are emerging markets back?

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0:26Pushkin. One asset class that normally just loves a drop in U.S. interest rates is emerging markets. and we're seeing a little bit of it again now. Lower US rates generally mean lower US bond yields and that makes higher yielding emerging market government bonds really stand out. Plus, the US economy is in pretty good shape and we have a load of stimulus that just landed from China. So, today on the show we're asking, is EM back? This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm Katie Martin, a markets columnist here at FT Towers in London, and I'm joined again down the line from New York City by that bright young thing, Aidan Reiter.

1:12Good morning. How are you doing, Aidan? I'm good. I was just home for the Jewish holidays and my mother said to me, you know, that Katie has the most lovely voice.

1:23Team Aidan's mom. I like that. So we're Team Aidan's mom, but we're also Team EM, right? Right. Like, why does EM, why do emerging markets like it when the U.S. is carrying rates? Yeah. Well, the U.S. is the standard of the world. So when you look at emerging market debt or any other government's debt, you're essentially looking at its yield relative to the United States. So if the U.S. is starting to come down, that makes those emerging markets that much more special, right? They look much better in comparison because U.S. rates are lower. Also, emerging markets tend to hike way higher. And in this cycle, they've actually hiked faster than the U.S.

1:58So they had their rates come up way before the US and other large economies. Yeah, this is the big thing about EM, right? So as soon as we kind of came through the immediate shock of COVID and supply chain started snarling up and inflation started picking up, all the kind of big, you know, Western central banks, effectively, look at the Fed, the Bank of England, the European Central Bank, they were like, this is just transitory. We're going to just sit on our hands for a little bit and see how this pans out. And the emerging markets were like, nope, we've seen this movie before and we are not having it.

2:28So they hiked quickly and hard. And hard. Yeah. So, you know, Brazil or Mexico, they had their rates above 10 % as opposed to, you know, in the three to five range in the EU, the US and the UK. So that makes them really appealing if you want to put your money there. But, you know, everybody loves the dollar. So when US rates are high, even if they're not as high as emerging markets, it just has the effect of sucking capital out of the emerging world. So Aidan, let's talk about what does emerging markets mean? Because it's a bit of a sort of, it's a bit of a squidgy term. And, you know, generally people take it to mean anything that's not kind of core, Europe, US, Canada, Japan, which, you know, Australia and stuff.

3:09But it's not a terribly useful term. No, as you said, it's kind of everyone except the big economies that you just named. And because of that, it's just like this really broad index that covers economies as disparate as Brazil and South Korea. South Korea has been, quote unquote, emerging forever. And they're kind of an advanced economy, but they're sometimes included in some of these indexes and conversations about emerging markets. So it just generally means like you are not Europe or you're not Western Europe, I should say, or the US or Canada. And at some point in the last 50 years, you were a, quote unquote, developing economy and you are not unabashedly a developed economy at this point.

3:47Listeners, you're going to have to bear with us here. There is just a bit of a kind of, There are gray areas all over this definition, but we're talking about economies that are not like major developed economies, G7 economies, G10. So I pulled some numbers actually before I came to record this. And so the MSCI Emerging Markets Index of stocks is up about 14, 15 percent in the past five years. Right. That's not terrible. But you compare that to the MSCI World Index and there you're looking at about 70 percent. Yeah. Yeah. Emerging markets can't keep up. Emerging markets can't keep up and you compare it to the S &P in the States and you've doubled your money on that thing over the same period.

4:24So it's just kind of not worth the faff, like doing the due diligence on emerging markets when you could just park your money in U.S. stocks and count it all rolling in. Yeah, which is a real shame, especially because, you know, emerging markets are ideally where there is the most room to grow and where the most amount of people could benefit from companies or stocks doing well. On top of that, on the government debt side, emerging markets not getting bond buyers is really, really catastrophic. We've had a lot of sovereign debt defaults over the last 20 years. And that essentially freezes up financing in an economy and punishes the poorest people in the world, usually.

5:00So it's just really, really unfortunate. And that's something that has been really concerning in the past five years. And it seems like we're starting to come out of the woods. Well, one, not a counterpoint to that, but one interesting wrinkle to that, I think, is that, and actually our colleague Robin Wigglesworth was writing about this the other day. One of the things that's happened in emerging market government debt over the past couple of decades, actually, is that they've shifted out of issuing bonds in dollars and much more into issuing bonds in their own home currency. And that makes a difference, right?

5:32Because in the event that they've issued debt in dollars and they have to pay it back in dollars, if their currencies crash because the dollar is really strong, because U.S. interest rates are really high, that effectively jacks up the cost of servicing their debt over the course of the lifetime of that bond. So to the extent that some of them have moved into local currency, does that dull the effect maybe of the shifts in U.S. policy here? Yes, to an extent. But at the end of the day, you still have to look at the yield, especially if it's government-issued debt, and you have to look at the yield relative to how yields are doing in the US.

6:05So if yields are still better in the US and you have a better bank for your buck in the US, people still put their money there and have more trust there. Also, a lot of emerging markets have rule of law issues as well as corruption issues that make them less appealing to some investors. That being said, local currency debt is probably set to do well in the next coming months. The US and the developed world affects all emerging markets. So if the US economy is achieving its soft landing and interest rates are going down, that means that there's going to be appreciation of local currencies. That gives these companies who have issued this debt more power to service other debts.

6:37It also results in those local currency bonds looking more appealing. So it's actually a pretty good moment to be in local currency debt on top of the structural elements of trying to insulate from dollar fluctuation. Now, one thing I've noticed, Aidan, is that the world is quite big. It is. It's quite large. And that means that there's quite a lot of difference from one emerging market country to the next, right? It's like, we're really bad people for talking about just like one block. And we get that. And we're very conscious that we're doing it. But you need a certain sort of shorthand to talk about the asset class.

7:10But there's some real kind of outliers and like weird things going on across the world. So on the same day that the Federal Reserve in the U.S. cut interest rates by half percentage point, all very exciting, Brazil raised interest rates for the first time in two years. It did. Like, what the flip is going on there? Yeah, it just seems like their economy is really hot and inflation's, you know, staging a bit of a comeback. So they're going to have to raise rates. Everything's been fluctuating, not as you would expect it, relative to the U.S. because they raised rates while the U.S. was lowering rates.

7:41You know, I think it speaks to the point of, you know, there is a large world, as you said, and other economies function differently and have different internal pressures. Not everybody is kind of the tail that's wagged by the U.S.'s dog. You could wonder which one's the tail and which is the dog here, because, you know, maybe Brazil is like a tale of things to come for the U.S. That, you know, if you have like a decent labor market and you've got a robust economy, then you're not actually in a position to cut interest rates as hard as you might like to. Yeah. The US is the kind of super tanker here, but sometimes it is worth looking at other smaller central banks to figure out, is this a situation the US is going to find itself in pretty soon?

8:19Because, you know, we don't want to go off on too much of this tangent, but already US markets are saying, a bit worried that the Fed might cut a little bit too hard here and maybe inflation is going to make a comeback. Perhaps the Brazilian example is something to look at, right? Absolutely. If past this prologue, Brazil started hiking rates way before the Fed and way before other, you know, global north central banks. So there's a precedent in the past couple of years of them being ahead of the curve. Also, when we talk about exceptions, we have to talk about China, right? China forever was considered to be an emerging market.

8:48Now, not so much. So when you look at MSCI, there's really two broad indicators of emerging market equities, which is MSCI emerging markets and MSCI ex-China, because China is just such a large part of MSCI world. Although interestingly, recently with China's stock rally, MSCI with China shot up again and shot up above MSCI without China. Now, this rally that we've had in China since you mentioned it, like we spoke about this the other week. Listeners, if you look back a little bit in your list of pods that we've done, you'll find we had a good chat about China. But the markets responded really kind of favorably to this, right?

9:26Just an enormous rally in Chinese stocks. It hit a bit of a wall, but nonetheless, you cannot argue with the size of that rally. And partly as a result of that, there's been a huge inflow into emerging market funds. So if you look at the numbers that come out from EPFR, they say they're getting the longest inflow streak into EM bond funds since the first half of last year. And an especially big push into Chinese equity funds, which has just helped to lift the whole EM investment fund space up to a new level. So it certainly looks like investors are sort of sitting up and taking notice here. Absolutely.

10:03But as we've said last time, without proper stimulus of the economy, that might not hold for Chinese equities. They've already been sliding in the past couple of days. So it could be that if there was any frenzy for EMs, including China, that might step off. But I do think there's going to continue to be interest in emerging markets beyond Brazil. Brazil is definitely heterodox. There's other economies that might have to raise rates. Nigeria has had a lot of funky things going on with their currency and their economy. Also, Turkey. Turkey has inflation that was catastrophically high for years and years.

10:35And recently, in the past two years, they've adopted a very, very stringent central bank policy. I think policy rates are around 50%. So it doesn't look like they're going to be lowering anytime soon because while some parts of inflation are coming down as a result of these high rates, not all sectors of inflation are coming down. So while it's good broadly for emerging markets, there are still some emerging markets that are these weird examples that don't really follow the same rules. Yeah. And Turkey always falls into that camp. It always does its own thing. It's a fascinating market, that one.

11:06EMs are looking better. EM local currency debt is looking better. And EM equities are looking better. But there's still a really big chance and risk of default. So for the past four years, because of issues in Ukraine, and then as well as the US rate hiking cycle, it looked like a lot of economies were going to default on their outstanding debt, which, as we said before, is just catastrophic. We've actually kind of come out of that. The IMF had been ringing the alarm bells and saying, this is bad, this is bad. We've come out with very few defaults, partially because some got rescued. You had Pakistan was bailed out by the IMF, as was Kenya.

11:39Maldives was bailed out by India. So we've managed to avoid the worst outcome. But just the other day, S &P Global said that the risk of default is going to be even higher going forward. And that's because while While economic conditions have improved, we still have some big structural hurdles for a lot of these economies to jump through. Also, a lot of these economies were able to avoid default by taking some less than ideal payouts and less than ideal loans, and that's resulted in going to be harder for them to access financing the future. So for example, Kenya. Kenya got an IMF bailout, which was really helpful to stop it from defaulting.

12:14But as we've seen with the local turmoil and unrest, they did so by slashing budgets in a way that people weren't super thrilled with. And on top of that, now they can't access the market in general because they still have to deal with that large loan and that large bailout they got from the IMF. So while we've avoided the worst, by doing so, by dancing around default, we may have just prolonged the problem and we could see more defaults going forward, especially if the economic outlook churns on the US or any other economy. Yeah, for sure. Not super thrilled is my descriptive phrase of choice from now on around IMF programs, which are generally considered to be pretty tough gruel.

12:58Okay, so you've got lower US rates, and if they stick to what they've previously indicated, then they're going to head lower still. You've got general kind of animal spirits around a pretty robust US economy, and that's good. You've still got the risk of some defaults. You've still got some slightly ugly idiosyncratic stories. and I'm led to believe that you Americans have got some sort of election coming up. Register to vote, listeners. We just don't know how that's going to pan out, particularly with regards to China around all the talk about tariffs and the two candidates have got quite different stances there.

13:30If Trump enacts tariffs across the board, which he said he will do, that'll really hurt EMs, right, who have trading relationships with the United States. And those are countries that don't really have a lot of margin for error and a lot of margin for change on their relationships with other economies, right? If they lose foreign inflows, especially dollar inflows, that'll make it harder to service their debt. It will make it harder for their countries. They could get more business from China, but there's also some issues between China and EMs as well. Also, a new administration in the White House or conflict between the US and China might also result in the US taking a less active role in dealing with IMF and helping with organizations like the International Development Association, which help economies deal with their large outstanding debt loans.

14:12So, you know, this election will be incredibly consequential for emerging markets. And, you know, we don't want to see more defaults because they enact a lot of pain both on the people in those economies, but also on the broader global economy. It's really not fun for everybody to get in line as creditors and deal with the various IMF and agencies in China and everybody who has to help them come to a deal on restructuring their loan. That's a really complicated, costly process. The global community is trying to improve it, but that is a really, really slow process. Yeah, it's complicated, it's costly, and it's a massive pain in the ass.

14:46So all of that having been said, what do you think on EM? Do you think this is the start of a bit of a renaissance? Or do you think this is all just a little bit of a flash in the pan because you have had the cut from the US? Yeah, I think if you look at EMs where they are today versus where they are two years ago, when everybody thought there were imminent defaults around the corner, they're looking great. And they've actually started to return way better. And they've navigated these crises quite well, considering all the things ahead of them. And also, as you said before, with U.S. interest rates coming down, it only is starting to look better for them.

15:17So hopefully this is a moment that will be sustained if the international community can make sure some of the sovereign debt infrastructure and architecture is resolved in case they do default down the line. and if the US economy and the global economy continues to achieve the soft landing. What do you think? I'm in team this is going to be okay because EM has been so under-owned. And so just this little waft of kind of supportive news from all these different places all at once has got to be a good thing for the asset class. I'm prepared to be proven wrong, but I hope that I'm right because it has just been off people's radar, like I say, for so long.

15:55Aidan, we're going to have to wrap it up there. but I have exciting news. Oh, do tell. Unhedged, listeners, is going on the road. We are going to be recording a live version of the show with an audience at the Kilcanomics Festival in Ireland on November the 9th. It's free, but it's sold out and I am, as a result, terrified. But we'd absolutely love to see you there and if you're heading to the festival, which is a good laugh and you should head to the Kilcanomics Festival, it might be worth seeing if there are any spaces that come free at the back on the day. So, yeah, listen up to see what I managed to come up with.

16:34And it should be fun. So we're going to be back in a minute with Long Shorts.

16:49Okie dokie. It's time for Long Short, that part of the show where we go long a thing we love or short A Thing We Hate. Aidan, what you got? I am short Netflix's research department. There's the show that everyone is talking about called Nobody Wants This. And it's about a Jewish man, a rabbi dating a non-Jewish woman. And there were so many inaccuracies about Judaism the first two episodes that I had to stop it. Just as a very quick example, they had services at the synagogue on a Friday night. And at night, you don't wear the talus, which is the ceremonial cloth. And they were all wearing them.

17:23And I was like, it's literally every Jew could have told you that. There are so many Jewish people in the United States who particularly work in Hollywood. You couldn't have asked anybody some of these very simple questions. Like I got so heated just while I was like, there's so many inaccuracies in episode one. Like, where is this going? That sounds really annoying. And I would have been the same if there was something about like scousers or something. What is your long and short, Katie? I am long swagger. Ooh. So there's a whole lot of like swagger going on in the UK at the moment. So we've just had this big like investment symposium.

17:56The government has been meeting with the great and the good from asset management, from industry and talking about, you know, the UK is open for business. And, you know, it always has been. But, you know, nonetheless, there's kind of this big kind of push. And so Poppy Gustafsson, who was formerly the CEO of Darktrace, which is a cybersecurity company, she's very much part of this big initiative to get London and get the UK back on the map. And she said, and I agree with her, when you're marketing into the US, you have to say, this is the best technology that has ever existed in the world. Whereas British marketing tends to be terribly sorry if you have a minute, possibly having a look.

18:34I kind of agree with her. So we're not very good at swagger in the UK, so I'm going to go long swagger. I'm going to swagger for the rest of the week. You've got to say this is the greatest stock of all time and we're going to list it on the footsie. This is the greatest podcast ever and you should vote for it in awards and all that sort of thing. Anyway, I digress. Listeners, we're going to be back on Thursday with a very special episode. No spoilers. Back in your ears then, so listen up. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein.

19:09We had additional help from Topher Forhez. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.

19:39We'll be right back.