Investors could be wrong to let currency devaluations in emerging markets colour their picture of the wider asset class, finds Fiona Rintoul.
“It was the best of times, it was the worst of times.” The opening line of Charles Dickens’ 1859 novel A Tale of Two Cities nicely sums up the current situation in emerging markets. Fundamentals are – broadly – good, but currencies have taken a pasting. Why?
Almost everyone agrees that currency devaluations that have plagued emerging markets since April are due to external factors. Neville Shaw, emerging and frontier markets portfolio manager at Mirabaud Asset Management, summarises the situation: “A stronger US dollar, typically negative for EM [emerging market] assets, coupled with rising concerns over protectionism and trade wars developing between the US and China, have put many investors off.”
The question now is about what this means for investors. Are they going to “get what they want at a cheaper price”, as Jan Dehn, head of research at Ashmore Investment Management, believes. Or are investors right to be worried about the impact of a trade war on the performance of emerging market assets?
Purely from a currency perspective, it may seem that there is little hope for improvement in the value of emerging market currencies as the Federal Reserve (Fed) embarks on a round of interest rate rises.
However, Brent David, senior emerging markets portfolio manager at BlueBay Asset Management, disputes the conventional wisdom that emerging market currencies cannot appreciate against the dollar when the Fed is tightening.
“We believe you can have tightening and currency appreciation as long as growth remains robust and synchronised across the globe,” he says.
In that scenario – or indeed any scenario – emerging market currencies should also benefit from sound central bank policy, David believes.
“The majority of EM central banks dealt well with a pretty significant EM crisis during the taper tantrum in 2013-16,” he says. “I would argue central banks in EM are particularly credible.”
In any case, just because a currency gets hammered on the markets, it doesn’t mean that there is a fundamental weakness, says Dehn.
“Currency traders are very bad at aligning currencies to fundamentals,” he says. “Technical dynamics creep in that create excess weakness.”
Andrew Bloomfield, associate director at Record Currency Management, also highlights wrong valuations in emerging market currencies – and the opportunities they create.
“If you look at EM currencies and adjust for productivity, they are 12%-13% undervalued against the US dollar,” he says. “That mis-valuation has been there for a while and got worse when the US dollar appreciated. It’s a good value opportunity, but timing is key.”
In other asset classes, there is perhaps even more room for optimism. The recent sell-off was of a comparable magnitude to the one five years ago at the start of the taper tantrum, notes Thierry Larose, local currency emerging market bond specialist at Vontobel Asset Management, “but with less reason”.
“Five years ago, the market was more expensive, and valuations were not compelling,” Larose says. “This time it’s more about buyer fatigue.”
If you assess the market by real yield on five-year emerging market local currency bonds versus US TIPS or look at the real effective exchange rate, he adds, it isn’t as expensive as it was before the taper tantrum. “For those smart enough to be away from the asset class, this is a good point to re-enter.”
On the equity side too, there is plenty of optimism among fund managers.
“After a very strong year in 2017 when we were up well over 40%, we are not surprised to see a pullback this year,” says John Malloy, co-head of the emerging and frontier market equity team at RWC Partners. “We continue to see opportunities in EM and frontier markets as we believe we are in a multi-year bull market.”
The ‘strong man’
Of course, emerging markets is a very broad term – some might say too broad – and there is considerable variation across these markets and many market-specific reasons for concern. Political risk is always a consideration in emerging markets, and that remains the case, even if sober central bankers provide comfort.
“In some of the big economies of the world, we’ve seen the rise of the strong man,” says Nicholas Morse, investment manager on the emerging market team at Comgest. “In the context of democracies, we’ve seen it in Hungary and Poland. In the more democratic Latin American world, there is a great deal of uncertainty.”
The recent Mexican election saw the socialist candidate become president, while the outcome of the Brazilian election in October is highly uncertain. This leaves a political question mark over Latin America’s two largest economies, while some will be concerned by the consolidation of power in one man’s hands in (separately) China, Turkey and Russia.
Meanwhile, RWC’s Malloy is far from alone when he says he is concerned about Turkey and South Africa from a macroeconomic perspective, while Mirabaud’s Shaw identifies deficit issues in Argentina and concerns about the effect of sanctions on Russia and of rising oil prices on some Asian energy importers.
“EM investors have started diverging along the usual fault lines, with assets from countries with higher external-funding needs suffering the most: for example, the Argentine peso and the Turkish lira have seen severe pressure year-to-date,” says Sergio Trigo Paz, head of emerging markets fixed income at BlackRock.
Many believe these uncertainties – combined with the threat of a trade war between the US and China – make for a stock-picker’s market where passive investors could be punished.
“Where you get greater divergence and less generic returns from EM, that increases the scope to add value through stock-picking,” says Morse at Comgest. “We are looking for companies that have a high degree of resilience to economic cycles.”
On the bond side, the same situation pertains, perhaps particularly in local currency bonds, Larose believes.
“It’s an asset class where passive is not the right strategy,” he says. “We want to discriminate and manage the portfolio with high conviction. We need the benchmark to measure relative performance but we don’t measure against the benchmark.”
However, overlying all the strong fundamentals in emerging markets, and all the stock-picking opportunities created by differentiation among markets and companies, is concern about the potential for a trade war between the US and China. Assessing the scale and impact of any such trade war is complicated by the character of President Trump.
“It’s not in his interests to push too far,” says Larose. But no one is betting that he won’t, and so Larose takes comfort from the US’s “strong institutions”.
The sense is that an all-out global trade war is unlikely but not impossible. Were it to happen, it would be negative for currencies, negative for growth and negative for equities.
“I find it difficult to provide a strong view,” says David. “At the margin, we’re bullish and think EM can offer value.”
At the same time, it’s possible to see a positive side to the trade discussions between the US and China – just as the peace talks with North Korea may have a positive side. “We believe that the trade discussions are just part of the United States’ larger negotiation tactics with economies all over the world,” says Shaw. “The United States’ massive trade deficit is negative for the world economy over the longer term.”
Shaw hopes President Trump’s economic policies will address these imbalances and result in fair trade. There is also the possibility that they could stimulate increased capital markets liberalisation in countries such as China.
Meanwhile, Dehn at Ashmore believes that the risk of protectionism has already been more than priced in.
“So far, American protectionism only really targets China,” he says. “Most individual countries trade so little with the US, there’s no point. I don’t see it as a big threat.”
If it isn’t a big threat, Dehn could be right in describing the emerging market opportunity right now as “juicy” and a “double sweet”.
The International Monetary Fund is predicting that emerging markets will grow faster than developed markets for the next five years. Real yields on emerging market bonds are high by historic standards and the quality is also high, with 95% rated investment grade. And the US, says Dehn, is falling into populist policies that have created a “sugar high” for the dollar and stocks.
“That sugar high is an amazing opportunity,” he says. “Investors can go back into EM bonds at levels they would have gone in at in 2016.”
Other metrics also speak in favour of emerging markets. Morse points to structural issues that have been in place for some time, such as the growing middle class in these markets, financial inclusion and the need for greater infrastructure.
But one fact perhaps speaks lounder than all others; according to data from the World Intellectual Property Organization, patent applications are now greater in emerging markets than in developed markets.
“Innovative venture capital investment and future growth is increasingly being built in EM,” says Morse.
This article first appeared in Funds Europe
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