Emerging markets face three major headwinds

Emerging market assets have enjoyed robust performance despite the Covid-19 pandemic, with investors attracted by their higher yields and faster economic growth prospects in these countries.

But three headwinds could cut short their growth spurt: rising interest rates, environmental, social and governance (ESG) issues and the retreat of globalisation.

These headwinds are converging at a very delicate time for global markets, and at least two of them could persist for a long time.

Let’s look at them in turn.

Rising interest rates

Whether to invest in emerging markets or not was until not long ago a rather easy decision: investors looked at their higher yields compared with developed markets, and decided to jump in.

However, with the Federal Reserve giving subtle signs of a shift to a lesser accommodative monetary policy, this decision will become much harder.

The 10-year US Treasury bond yield was around 1.662% last Friday compared with 0.955% at the beginning of the year.

This rise in the yield of the world’s most liquid debt instrument, which is usually seen as a safe haven, weakens the case for investing in emerging markets.

After all, why should investors take the risk of putting their money in instruments with higher probabilities of defaulting, when they can get positive and rising yields at home?

And this is not the only reason why rising US Treasury yields are bad for emerging markets. A tightening of monetary conditions will make it harder for companies in these countries to obtain funds to invest, and this could act like a brake on growth.

Governments in emerging markets could suffer too, because interest payments on their existing debt could increase and it could become more difficult for them to borrow more on the international markets.

On the brighter side, rising interest rates could prove to be a short-lived headwind. The Fed and other major central banks have been at pains to stress that they would not do anything to jeopardise the fragile economic recovery.

ESG issues

The dispute between China and Western nations regarding the former’s treatment of its Uighur minority is just the start of a trend that will see more scrutiny over human rights, social and governance issues in developing countries, along with environment protection measures.

In a coordinated effort, the European Union, the UK, US and Canada introduced sanctions on China because of human rights abuses against Muslim Uighurs.

Many Uighurs are detained in camps in Xinjiang, a region in the north-west of China, and allegations of forced labour, torture and sexual abuse have periodically surfaced.

China denies that such abuses take place, calling these camps “re-education” facilities – a word which, despite its seemingly innocuous meaning, still sends shivers down the spine for those born under communism in countries in eastern Europe.

The political prison camps in certain eastern European countries, where millions of people died of torture, untreated diseases, lack of food and lack of basic sanitation measures during communism, were also called “re-education” facilities.

Investors’ concern is likely to go beyond China. Issues such as corruption, gender inequality and discrimination, human rights breaches, weak governance, are sadly quite often present in emerging markets.

In a Western world that declares itself more preoccupied by ESG issues than ever, these issues will come more into focus for investors.

Globalisation in retreat

The Covid-19 pandemic has already disrupted our lives unlike any other event in the post-war world. Its effects are likely to reshape global economies in years to come.

Globalisation in retreat could pose a threat to emerging markets.

Even before the pandemic, globalisation was increasingly becoming a dirty word. Populist movements in the West were promising to cut it down, either by bringing back offshored industries, or by reducing immigration.

Covid-19 could accelerate both these trends. The breakdown in supply chains in the early days of the pandemic caused chaos not only in shops but also to distribution companies in general, as items such as shipping containers became unavailable.

The recent blocking of the Suez Canal by the huge merchant ship Ever Green is a good example of why too much reliance on imported goods could be dangerous for a country’s economy.

With every day the canal is blocked, the backlog of goods increases and the risk of shortages of goods in shops and materials in factories rises.

Another good example of why it could be a good idea to bring back some strategic industries is the case of India. The government of the country that would like to be known as the pharmaceuticals manufacturer of the world has recently suspended exports of AstraZeneca’s vaccine against Covid-19.

The UK, which was getting ready to extend vaccination to people aged under 50, has announced that the plans are delayed partly due to delays in supplies from India’s Serum Institute.

Meanwhile India is extending vaccinations to people above the age of 45, in efforts to bring the virus under control.

While it is understandable that the Indian government wants to make sure its citizens benefit from the Covid-19 vaccine, only time will tell how damaging the decision to suspend exports has been for the country’s reputation as an offshoring hub, not just for vaccine production but for other industries as well.

Businesses and governments will look at this and see an example of what could happen when they decide to move crucial production outside of a country or region where they have some decision power.

It is hard to tell just yet how bad these three headwinds will ultimately be. But investors in emerging markets should certainly pay attention to them.