Apart from Donald Trump’s daily tweets, news headlines these days are dominated by financial woes in Emerging Markets. Argentina and Turkey vie for the title of having the weakest currency (both down by more than 40% against the dollar since the start of this year) but also other Emerging Markets are showing signs of stress. For example, both the Russian rouble and the South African rand depreciated by 15% against the dollar this year. In the past, Emerging Markets have shown a tendency to deteriorate synchronously, where financial stress in one country led to stress in another. This, for example, was the case during the Asian crisis in the 1997. Should we, therefore, again worry about contagion?

The main driver for contagion is the need for foreign funding. Countries with a high current account deficit, weak credit metrics (as expressed by a fiscal deficit and high debt level) and low FX reserves are most at risk. This is exacerbated when funding sources are mainly denominated in foreign currency or when local currency bonds are mainly held by foreigners. Argentina and Turkey fit this bill and both countries are in the middle of a classic balance of payments crisis. Argentina has a high public debt level (54% of GDP before the plunge in the peso) as well as significant short-term debt roll-over requirements (think of the Lebacs). Turkey’s public debt is modest but its corporates have borrowed heavily and Turkey also relies on short-term foreign capital. A reduction in global liquidity (due to higher dollar rates and a stronger dollar) and increased (credit) risk awareness earlier this year resulted in a reversal of fortune as foreign capital inflows dried up. Both countries will need to make painful adjustments to correct the imbalances (Argentina’s government is doing so but Turkey’s supreme leader is still in denial).

Argentina is being tormented lately…

Clearly, the decline in dollar liquidity has also affected other Emerging Markets and as such one could indeed speak of contagion. However, fundamentals generally are much better than during the Asian crisis (though have deteriorated since 2008). One year before the Asian crisis, Korea, Malaysia and Thailand were running large current account deficits (-8% in the case of Thailand). Now these countries run surpluses (+9% in the case of Thailand) and hold significant FX reserves (though since 2008, Malaysia has seen high external private debt growth). Most other countries that experienced a currency sell-off also have much better fundamentals than before. For example, Russian US$ sovereign debt returned -3.35% this year with spreads widening by 0.56%, but the country has a current account surplus of 4.5%, low public debt (18% of GDP), US$ 370 billion in FX reserves and (this year) a balanced budget. Of course, sanctions are a negative for Russia’s economic growth potential and the economy is heavily dependent on the price of oil, but a credit default, in our view, doesn’t seem on the horizon any time soon. India and Indonesia, categorized under the “fragile five” during 2013’s taper tantrum, are obviously not immune to a pullback but both countries experience decent growth and have adopted appropriate fiscal and monetary policies. Though both countries run twin deficits, they also maintain high FX reserves whereas the current account deficit is mostly caused by foreign direct investments as opposed to fickle portfolio flows. Furthermore, Indonesia’s public debt level at 30% of GDP is modest.

That is not to say that everything is hunky-dory in Emerging Markets. Brazil experienced balance of payments stress in 2014 after the collapse of the oil price. The country’s central bank acted appropriately, hiking rates to 14% and thereby depressing economic activity and inflation. Non-resident holdings of local currency government bonds dropped from 20% to a low 12%, reducing pressure on the currency, especially as external public debt is only 3.6% of GDP. Brazil runs a small current account deficit but this is amply covered by FDI. However, the government balance sheet is out of control with a fiscal deficit running at -7.5% this year (though financed by domestic savings, which increased thanks to the depressed economy). In order to bring public debt on a sustainable path, the government needs to address its spending by cutting into too generous pension and social benefits. This may be difficult given the political landscape. Jair Bolsonaro, a right-wing Trump-like populist, is ahead in polls for the upcoming presidential elections in October. He may adopt orthodox macroeconomic policies but may have difficulty getting reforms approved in Congress as he probably will struggle to assemble a majority. The likely alternative, Fernando Haddad, a Lula stand-in of the socialist Workers Party, is even a worse prospect as he probably will reverse some of the modest reforms enacted by the current president. South Africa is another cause for concern and is likely to run into a balance of payment crisis given its ineffective government, high dependency on foreign funding (40%), upward pressure on inflation (partly caused by weak currency as the rand dropped by 15% this year), low FX reserves (US$ 45 billion) compared to short-term debt and a persistently high current account deficit (-3.6% of GDP). With the 5-year CDS trading at 2.35%, risks are not yet properly priced in, in our view.

The biggest source of contagion risk probably comes from China. If China’s economy experiences a significant slowdown because of the consequences of its unsustainable debt growth and/or a severe trade war with the U.S., neighbouring countries will be hit as their (export) economies are intimately linked with China’s. Also, suppliers of commodities could be hurt (Chile, a big copper producer, in particular is vulnerable). Although, thanks to capital controls, the authorities have levers to avoid a hard landing of the economy (as they now are busy doing), we remain nervous of the potential impact of policy errors.

So contagion still is an issue in Emerging Markets, which should not be a big surprise given the increased interconnectedness of the global economy through supply chains. Also, investors have secularly high exposure to Emerging Markets, although less leverage is applied than in the financial crisis of 2008 and institutional investors and mutual funds hold an increasing share of the assets (as opposed to banks that dominated Emerging Markets asset ownership in the 80s and 90s). We do expect further pain if and when U.S. interest rates are hiked later this year and the sell-off continues. However, generally Emerging Markets are in much better shape than in previous crises and are less monolithic than in the past, which might create interesting investment opportunities when investors do not recognize the wide differences that exist between Emerging Markets. For example, the price action in Indonesia (local currency debt yields 8.4% with expected inflation at 3.5-4%, resulting in an attractive real rate of more than 4%) looks somewhat overdone, whereas Russian equities look cheap on basis of any valuation metric (P/E of 5.5, price-to-book of 0.77 and expected dividend yield of 6.5%). Argentina’s 60% interest rate on local currency bonds starts to look attractive on a risk-adjusted basis. Maybe time to come in from the cold…