2016 and before
Can the emerging markets revival continue?
Our panel of experts reflect on the revival seen in emerging markets this year, and discuss whether it is set to continue in 2017 in the wake of the recent US presidential election result.
Will the US election result hamper the emerging markets revival?
Given the uncertainty over US policy under President Trump, Multi-Asset Fund Manager Ugo Montrucchio said we should wait and see. “I think it is premature to draw a conclusion because we would have to see some concrete facts on the table, in terms of what the change in leadership will bring.”
Nicholas Field, Global Emerging Market Equity Strategist, shared this view, but emphasised the importance of the US dollar.
“The key variable for us is the US dollar, which tends to drive equity returns. Although the initial reaction to the election has been to see some strengthening in the dollar, we don’t know whether that is going to continue and that will depend very much on what policy mix actually comes out next year. That remains very uncertain.”
China in focus
Field noted that although future US policy and the potential impact on China’s economy is uncertain, he did not expect the domestic outlook to change significantly.
“We would expect growth to continue to slow and for the currency to devalue moderately but continuously, and we don’t expect an enormous crisis,” he said.
“The reason we are not more pessimistic, despite the massive build-up in debt in China, is because the Chinese government owns most of the banks so it can control and manage a crisis. What it can’t do is maintain strong growth levels and keep the currency up at the same time as managing the debt”.
Fed policy and emerging markets?
As the discussion moved on to the impact of expected policy tightening from the US Federal Reserve (Fed), Montrucchio contrasted today’s environment with the so called “taper tantrum” of 2013, when the Fed announced plans to cease quantitative easing.
US Treasury yields surged following the news and led to large falls in emerging markets stocks, bonds and currencies.
“The balance sheets of emerging markets in general are much sounder than they were three years ago”. On the interest rate side, he thinks “the real yield component is sufficiently high to withstand some sort of short-term shock”.
Much will depend on what accompanies dollar strength. In Montrucchio’s view, a sudden shift in expectations and a progressive tightening of policy “could easily see a reversal of the tidal wave of liquidity that benefited emerging markets over the last year.”
“However, if the strengthening of the dollar is accompanied by a reflationary1 story, i.e growth actually accelerates globally on the back of what happens in the US, we could actually end up in an environment where dollar strength is mirrored by emerging market strength, which is something which we saw in some parts of the 1990s for example.”
Are emerging currencies cheap?
James Barrineau pointed out the almost 50% decline in the average emerging market currency between May 2013 and January 2016. And more specifically, he highlighted that June 2014 to January 2016 was the, “worst period for emerging market local currency returns in history.”
“We essentially wiped out the commodities super cycle which drove real exchange rates very high in a number of emerging market countries,” he said.
Despite a significant appreciation in emerging currencies from January this year until early November, Barrineau thinks it is difficult to characterise them as expensive.
“If you look at real exchange rates2, they are still in general significantly lower than they were at their peaks. Real interest rates are slightly positive in general, as opposed to developed markets. So I would say they are more fair value than particularly expensive”.
Where are the opportunities in emerging markets?
From an emerging market bonds (or emerging market debt, EMD) perspective’, Barrineau cited Brazil, “because real rates remain above 6%. Unless we get a significant amount of volatility predicated upon a much stronger dollar, a much stronger reflationary trade impulse, they should be able to continue to cut rates”.
He added that emerging Europe also offers potential opportunities given that these countries would be less affected by a protectionist US.
Barrineau also noted that a December Fed rate hike is now priced-in, with two further rate rises in 2017 close to being priced-in. In his view, a higher pace to rate rises is unlikely and consequently there remains a “significant opportunity in some of the higher yielding parts of the EM debt complex”.
On the equity side, Field also viewed Brazil as a significant opportunity, given optimism for interest rate cuts.
“We particularly like the growth possibility in Brazil, but also in Russia,” he said. “You have two economies which have been shrinking at a rate of around 2.5% per annum for the last year and half; quite deep recessions.
"The likelihood is that they return to modest growth next year. We are not looking for very much, but it is a big change from- 2.5% to +0.5%, and that can drive quite a lot of recovery in domestic equity earnings, supported by interest rates cuts as well.
"We don’t think at this stage that the US dollar concern is significant enough to derail that process.”
Capital flows into emerging markets
After experiencing strong capital flows to emerging markets this year, there was a significant reversal in the week following the election of Donald Trump.
In Barrineau’s view, “the interesting thing about emerging market fixed income is that it is now increasingly driven by ETF flows, which was never the case in emerging markets, compared especially to US high yield3.”
He pointed out that this contributed to “some indiscriminate selling of the more liquid portion of EM dollar debt” in the last week. However, for active managers he sees this as more of an “opportunity creator than a problem.”
While he would expect a pause in emerging markets flows in the near-term, he did not see institutions rotate significantly into EMD in 2016 and said there is still significant scope for them to increase their allocations.
Field agreed with the other panellists, drawing attention to the fact that while this year saw inflows to emerging markets, “this is against a backdrop of more or less persistent outflows since 2010”. He said the “huge underweight” built up by both retail and institutional investors has not been unwound.
“Although one can see with recent US dollar concerns and election issues that there might be a pause, there is potentially plenty of room for institutions and retail to increase their exposure to emerging markets equities.”
From a risk/return perspective, will bonds or equities perform better in 2017?
Montrucchio thinks the dilemma for next year is which of two scenarios will come to the fore.
“Will the reflationary story take hold very quickly, and US consumer spending and wage inflation accelerate? Or will the expectation over what will happen in 2018 and beyond lead us to a world where monetary policy will excessively tighten and the dollar will excessively rise?”
He currently believes that, at least from a developed market perspective, equities have more potential than bonds. However, the answer to this question will in his view depend on: "a) concrete terminology about policy mix in the US and b) the reaction function of the central banks to that policy mix.”
If the reflationary theme is the driver of markets in 2017, Barrineau expects equities to do better than bonds. “But if we see that has gone too far too fast, there is a significant opportunity for bonds to do very well.”
Field views emerging market equities as cheap following “a structural decline in return-on-equity4(ROE) which led to very low price-to-book ratios”5. Beyond the ups and downs of US policy, he thinks the question is the degree to which emerging markets have adjusted following the decline in the commodities supercycle6.
“For a few countries where we have seen quite sharp recessions, that is the case and we can look for an improvement in those ROEs,” he said.
“This means those valuations are cheap and you could do quite well in equities there over the next two to three years. The only thing which would really upset that would be some really quite violent moves out of the US in terms of the US dollar and rates.”
1. Reflationary policies use fiscal or monetary measures to stimulate the economy with the aim of bringing prices back up to long-term trend after a dip in the business cycle.↩
2. A real exchange rate is effectively the purchasing power of a currency compared to another foreign currency based on current exchange rates and prices.↩
3. A high yield bond is a bond with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon.↩
4. Return-on-Equity is a measure of the profitability of a company. Effectively, how much profit a company generates with the money shareholders have invested. For example, if a company's equity is valued at £10 million and it makes a profit of £1 million, the return on equity or ROE is 10%.↩
5. Price-to-book value is a ratio used to compare a company's share price with its book value (the book value is the actual value of the company assets minus its liabilities).↩
6. The commodities supercycle was the rise and subsequent fall of many commodity prices that took place between 2000-2014. It is termed supercycle due to the prolonged period of above-trend movement in prices.↩