- Volatility has returned to emerging markets following a period of relative calm
- Blame has fallen squarely on the strong dollar and rising rates
- Excessive pessimism has distracted investors from the strength of emerging markets
Over the years, emerging market investors may have learned to be wary of the mill pond. Too often, it can disguise the waiting shoal of piranha fish beneath. At the start of this year emerging markets seemed to be at a point of historic calm, with global growth ticking higher, reform progressing and geopolitical risk receding. Since then, volatility has returned with a vengeance.
The question for investors is whether this is simply back to normal for emerging markets. They have historically been volatile, vulnerable to the ebb and flow of the global economy and investors have had to take the rough with the smooth. The alternative scenario is that investors have misread some fundamental changes in the structure of emerging markets. If this is the case, the latest rout may represent an opportunity.
The current difficulties in emerging markets should be put in context. The MSCI EM index is down almost 6% in three months, but it’s still up 14% over the past year. However, it has undoubtedly been a tricky time for some emerging markets. Currencies have taken a significant hit, and countries such as Argentina and Turkey have seen double-digit falls in their stock markets.
The catalyst for much of this weakness is the stronger dollar and rising US interest rates. The theory runs that a higher dollar and higher rates spell bad news for emerging markets because it inflates the cost of their dollar-denominated government and corporate debt. They may be forced to adopt a monetary policy that is inappropriate for their own economies.
However, while this view is widely held, it does not have a lot of historical evidence to support it. Certainly, this phenomenon was witnessed in the ‘taper tantrum’ of 2013 (the last time US government bond yields saw a significant rise), but in other instances investors have seen stronger growth in emerging markets as US 10-year bond yields have risen. This makes sense – US interest rates usually rise in response to improving global growth, which in turn tends to benefit emerging markets.
Another widely-held view is that there is natural contagion in emerging markets – if one falls, they all fall. We would certainly argue for selectivity, but that is not the same as saying that China is likely to be derailed by problems in Argentina or Turkey (the opposite may be true, but it is not the case today). Emerging markets are subject to international fund flows and there will be ‘tourists’ during boom times. They can result in a seemingly natural correlation between emerging markets, but it is a short-term phenomenon rather than a having link to the fundamentals of emerging market companies.
And those fundamentals are encouraging. Earnings for emerging market companies are still strong and we believe this is being neglected amid a focus on external factors. At the same time, investors are paying less for that strong growth, with valuations much lower than their developed market equivalents. At the start of the year investors could see no wrong in emerging markets, now, some 5% lower, with proven corporate earnings, they are suddenly worried. To our mind, that seems the wrong way round.
This focus on external factors comes at a time when emerging markets increasingly stand on their own feet. Emerging market corporates increasingly distribute regionally rather than globally, and while the impact of a trade war between the US and China cannot be dismissed, we see it creating problems on both sides, not simply for emerging markets.
Nevertheless, this turmoil brings with it opportunities. We have been underweight in Latin America for some time, but after a significant correction in the currencies and stock markets, we are reconsidering some of the opportunities there. There are also opportunities emerging in some of the smaller emerging markets within Africa, the Middle East and Eastern Europe. These can be off-the-radar for international investors and hide some unique companies with strong growth.
There are, undoubtedly, places to avoid. Argentina had moved very quickly from an investment pariah to issuing 100-year bonds in the debt markets. With hindsight, this looks optimistic and suggestive of over-exuberance, no matter how strong the reform agenda. There are pockets of over-valuation. We would put India in that camp, for example. The market had got ahead of itself.
This time, we would tentatively argue, there are no piranhas. At least not enough to do any real damage. Global investors have been swept along in the prevailing pessimistic mood. Not all is perfect in emerging markets, but from earnings to valuations, there is much to be optimistic about.
*MSCI Emerging Markets Index figures as of 21/06/18
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