Is the emerging markets revival sustainable?
We gathered a panel of emerging market (EM) fund managers at our recent investment conference in Madrid to debate whether the strong recent performance of EM equities and EM debt (EMD) can continue.
EM equities, as measured by the MSCI Emerging Markets Index, have returned 27%* year-to-date while local EMD, as measured by the JP Morgan Global Bond Index Emerging Markets, has returned around 14%*.
*As at 28 October 2017. Source Bloomberg
How sustainable is the rally in EM?
Tom Wilson, Head of Emerging Market Equities: “Given the 9% year-to-date fall in the Bloomberg Dollar Spot index (which measures the performance of the dollar versus 10 leading global currencies), and following the Federal Reserve’s (Fed) announcement of balance sheet reduction, there is the prospect of a near-term consolidation in the US dollar. However, on a medium term basis we still think there is a bias for further dollar weakness and, to a certain extent, a virtuous cycle for EM as a result of that ongoing dollar depreciation.
“Global trade remains in good shape despite expectations for a modest deceleration in Chinese growth through the back end of the year. We are not excessively concerned about China from a debt standpoint. We think the government has the levers to exercise control and manage the economy successfully.
“Overall in EM equities, aggregate valuations are in line with the long run average on a price-to-book ratio1 basis, but we think aggregate return-on-equity2 could continue to lift from here. Maybe the market sees a bit of a pause for breath following a strong run, but looking on a longer term horizon we still think they could offer an attractive upside opportunity.”
Are you concerned about any geopolitical factors?
Tom Wilson: “North Korea is interesting because South Korea is a country we favour in our portfolios. We ascribe an extremely low risk to a military conflict in North Korea. In our view, what actually mattered from an economic and corporate perspective was THAAD missile defence system deployment, which came in advance of the North Korea situation really flaring up recently.
“THAAD deployment has increased tensions between China and South Korea. China is an important market for Korean exports and there has been a marked negative drag on the sale of South Korean goods in the Chinese market, as well as a material decline in the numbers of Chinese tourists to South Korea.
“As a consequence of full THAAD deployment, it may take somewhat longer for the trade situation to normalise between South Korea and China.”
Is the Fed ceasing quantitative easing going to push the dollar up and cause the cards to come tumbling down in local currency debt throughout EM?
Guillermo Besaccia, Fund Manager, Emerging Market Debt: “It has been very important to understand cycles and broad movements in markets. In the past few years we have seen a dollar strength move which reached its seventh year of improvement in 2016.
“We have been broadly of the view that the bottoming of commodity prices in 2015 coincided with the full discount of the negative news in most EM - albeit China is a special case. Today, we think the election of Donald Trump probably marked the peak of the positive dollar move.
“The fact that the euro and other currencies, including a few EM currencies, are reaching new highs is quite an encouraging positive sign towards a broader positive cycle for EM against the dollar.
“In our view, cycles; political cycles, economic cycles, market cycles are sort of being tied together. The bullishness of Donald Trump in the US coincided with the turnaround of the bearishness on Europe as a bloc after the elections.
“The political cycle that has taken place in EM, notably in the case of Latin America, points to a potential for more structural decline of the dollar that we need to monitor and take advantage of.”
How much do you think Asian fixed income investors should take these geopolitical issues into account?
Rajeev De Mello, Head of Asian Fixed income & Co-Head of EMD Relative: “It is difficult for markets to price-in some geopolitical events. Markets are a little bit dulled because they can rely on quantitative easing policies from major central banks. Despite the flare-up in tensions in recent weeks, the Korean won has hardly moved.
“Investors are looking for market dips to invest funds accumulated from selling bonds to the European Central Bank and Bank of Japan. Consequently, Asian corporate bonds have seen record year-to-date new issuance, and that has been snapped up because investors have very little choice.”
You said there has been record corporate bond issuance in Asia this year. How is that money being used, are companies investing for the future or is there some kind of financial engineering going on?
Rajeev De Mello: “In the past companies in Asia have generally relied on banks for funding, like they did in Europe before the euro, and corporate bond development has been a phenomenon over the last ten years.
“Bank funding was typically shorter term but often lower cost. Now, however, yield curves3 have come down, spreads4 have come in and these companies are seeing that they can actually borrow money for longer term.
“So in a way it is financial optimisation, but in a way it is also healthier to borrow for projects at a maturity that corresponds to the investment. I wouldn’t be alarmed by the fact that they are accessing the corporate bond market.”
How do you feel that the opportunities are spread between EM in the various different asset classes that you invest in? How do you assess the opportunity?
Aymeric Forest, Head of Global Income, Multi-Asset Investment: “Traditionally, there was not really room for multi-asset EM, simply because correlation between EM equities, US dollar debt or local debt was high. However, the nature of EM has changed in terms of improving fundamentals, governance and a wider range of available financial instruments.
“In addition to changes in nature, there have also been changes in the composition of indices, for example, new China versus old China. By looking between and within asset classes, one can find negative correlation between assets which creates opportunities for multi-asset strategies to look at the universe on a cross-sectional basis.
“Consequently, we are likely to see more and more multi-asset strategies within EM in the coming years.”
When you talk about technology in EM, particularly in equities, what do you mean?
Tom Wilson: “When you think about IT in general for EM, there are three key industries, and you need to drill down to the industry level to better understand the sector:
- Internet software
- Electronic components
“Within internet software, we have not materially scaled back our positions because we think these stocks could be good compound growth opportunities. Many of these companies have shown a great deal of success in redeploying the cash flow that they generate into increasing their market dominance, in effect by developing their ecosystem.
“From an electronic components standpoint, we have taken some money off the table, primarily because these stocks typically perform well into the iPhone launch, and valuation multiples (ratios used to value stocks, e.g. price-to-earnings) have moved towards the top of their historic ranges.
“In the semiconductor industry we have modestly reduced our exposure but valuations remain attractive.”
Which EM currencies do you like?
Guillermo Besaccia: “From last year onwards we have seen pockets of value in local currency EMD, some once-in-a-decade opportunities.
“Broadly speaking we have been invested in markets including Brazil, Russia, South Africa, Indonesia and also Argentina. So far we have had the best performance from Mexico this year.
“The key question is how much further can monetary policy be eased? Politically and economically there is a positive cycle, allowing for real rates to be even lower than they were in previous years. So there are still encouraging signs.”
EMD spreads (the difference in yield between EM bonds and US Treasuries) are extremely low. Do you expect to see a widening as monetary policy stimulus is pulled out in the US and Europe?
Rajeev De Mello: “If one looks back at history to various episodes of Fed tightening or policy tightening that is the pattern; by the time the Fed actually starts, the worst for EM is over. Consequently, we believe the impact of Fed tightening on spreads is likely behind us.
“The spreads between local governments and treasuries, which have a currency component, have narrowed as the yields of many of those countries have really come down. Many EM have cut interest rates as inflation is falling. This lower inflation is partly attributable to currency appreciation but also due to more macroeconomic prudence, particularly in Asia, compared to the past. If one looks at the volatility of inflation, growth and currencies, all have declined significantly in the last 20 years. So countries have very strong anchors.”
Which areas do you see that new sectors or traditional correlations breaking down in EM?
Aymeric Forest: “China’s new economy still offers a lot of growth for 2018. Valuations are now less attractive but there is still potential there.
“We have avoided South Africa primarily for political reasons but also due to weak growth. However, the central bank has the potential to cut rates as inflation eases. So the ANC Congress in December will be critical, especially for the stockmarket but also the currency. We are watching that as a potential value opportunity.”
What would you invest your own money in within EM?
Tom Wilson: “EM small cap is an interesting opportunity as there is very broad and inefficient universe of stocks. If you have a decent sized team of experienced individuals who can turn over the stones and find the ideas, you should be able to generate returns in the EM small cap space through time. In addition, this can be achieved with a portfolio of around 70-90 stocks, diversifying away a degree of stock specific risk.”
Guillermo Besaccia: “We always go for the area with most value. On this basis, EM local currency is still the place to be. We have had a significant level of correction and adjustment and what we have had so far is just a small token of a potential turnaround. This is tied to the US dollar but related to this topic is also commodities. The asset class has started to show some life and we may see additional surprises going forward.”
Rajeev De Mello: “I think that in a portfolio, what could be interesting for investors are Chinese bonds. If you look at correlations, China's bonds have a very low correlation with bonds to the rest of the world. Recently, Chinese authorities have been tightening monetary policy while other countries are on hold or loosening policy. So I think it could be an attractive opportunity, plus they have defensive characteristics.”
Aymeric Forest: “I would prefer a combination of these strategies. We are currently overweight EM equities, and prefer local bonds to US dollar bonds, although we believe we are closer to the end of the loosening cycle in EM. We anticipate a peak in global liquidity towards the end of 2018, meaning investors will have to be more selective and broaden their horizon with a focus on correlations.”
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall. Emerging markets generally carry greater political, legal, counterparty and operational risk.
1. The 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).↩
2. 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%.↩
3. The yield curve is a graphical line which plots the interest rates, at a set point in time, of bonds with different maturity dates but equal credit quality.↩
4. The difference in yield between different types of bonds (for example, between government bonds and corporate bonds).↩
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