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With emerging market assets under pressure on the back of rising US interest rates, a strong dollar and an escalating trade war between the US and China, our equity and bond teams give their opinion on areas to avoid and where pockets of value are emerging.
2018 has proven troublesome for investors in emerging markets. Both equities and bonds have suffered heavy declines as rising US interest rates and a stronger dollar caused investment flows to reverse course. Sentiment has been further undermined by an escalating trade war between the US and China, and a slowdown in the latter country’s economy.
Initially Argentina and Turkey took centre stage, with both nations’ currencies plunging to record lows as investors pulled money from two countries seen to be especially reliant on foreign capital.
However, the selling has spread further afield as investors try to assess which other countries are most vulnerable to a tightening of global monetary conditions. With the MSCI EM equity index down by more than 17 per cent in US dollar terms from its January peak and bond indices having fallen sharply too – JP Morgan’s emerging market local currency bond index returned -8.4 per cent in US dollar terms in the nine months to the end of September – the big question facing investors is whether emerging markets are over the worst, or the situation could deteriorate further.
US rates hit EM debt
According to Aaron Grehan, deputy head of emerging market debt at Aviva Investors, the outcome mostly hinges on what happens to US interest rates.
“A limited rise so far has been the catalyst for some significant issues. These problems would likely intensify if we got a further big increase in rates,” he says.
Until recently, the consensus opinion was that any sell-off would be of a lesser magnitude to the so-called taper tantrum of the summer of 2013. However, with the decline in prices already approaching those levels, and the macroeconomic environment facing many countries continuing to sour, Grehan believes there is justifiable concern the challenges facing markets will not dissipate in a hurry.
“To date the sell-off has been relatively contained, with the likes of Turkey and Argentina bearing the brunt of the selling pressure. While other less highly-rated countries’ debt has also sold off in sympathy, there’s a risk the pressure intensifies,” he adds. “In aggregate, countries haven’t had enough time and or willingness to improve their fiscal positions and, subsequently, lower quality ‘B’ rated credits are in a materially weaker position.”.
Divergence increasing within EMD universe
He is concerned the likes of Lebanon, Ecuador and Egypt, which are all reliant on external financing, will not be able to maintain market access, and is avoiding each of these nations’ bonds as a result.
On the other hand, Grehan draws encouragement from the performance of more highly-rated market segments, noting the spread premium offered by investment grade debt relative to US Treasuries has actually declined over the course of this year.
“The long-term stability in credit quality in the IG universe paints a very different picture to ‘B’ rated credits. Concerns the sell-off could become more widespread misunderstand the differences in countries’ credit quality and the risks they face,” he says.
Within the investment grade segment of the market, his current preference is for debt issued by selective Middle East countries, particularly Qatar. Grehan notes that the spread on a 30-year bond issued by Qatar in April at a yield 205 basis points over comparable US Treasuries, has declined 40 basis points.
“This illustrates that selecting the right countries is key to generating attractive longer-term returns that still exist in the asset class,” Grehan says.
EM equities: valuations improve, but risks remain
Aviva Investors’ head of emerging market equities, Alistair Way, similarly believes that while the sell-off has left valuations looking attractive, sizeable risks remain; particularly if the dollar were to rise further on the back of higher US interest rates and trade tensions deteriorate.
“We’ve seen quite a sharp sell-off. There’s a view that it’s a pro-cyclical asset class that struggles when the dollar’s rising and I don’t see that changing,” Way says.
He adds that while corporate earnings have held up reasonably well, “there’s not been enough of a positive story to help markets break out of the current downturn”.
On the other hand, since shares are now looking much cheaper than they have for a while, and certainly relative to developed markets – for instance, emerging market companies’ price-to-book ratios are now 30 per cent cheaper than those of their developed market peers, around double the average discount level seen over the past 16 years – it would be wrong to be overly bearish.
Way is wary of Indonesian and Brazilian stocks, with investors likely to continue to fret over those countries that are simultaneously running budget and current account deficits.
However, he adds, it is important to recognise emerging market indices are today increasingly dominated by companies based in Asian nations boasting large and relatively stable economies.
“China, Korea and Taiwan are the big moving parts in the index. While there’s a lot of speculation about the stability of the Chinese economy, it seems policymakers have got things pretty much under control. The fundamental stability of these countries and their lack of sensitivity to the global rate cycle and currency movements is reassuring,” Way says.
With Aviva Investors’ portfolios having for some time been tilted towards higher-quality companies with strong balance sheets and attractive dividend yields, he is looking to gradually boost exposure to up-and-coming companies with the scope for “transformational earnings growth”.
He sees a number of attractive investment opportunities in the Chinese market, which has been among the worst performing this year.
“It’s a very dynamic economy with lots of up and coming companies available at quite cheap valuations, which is exactly what we’re looking for,” Way says.
He is especially interested in companies focused on the domestic consumer and services sectors, and is also looking at the technology sector where there are some “really exciting companies from a longer-term perspective” and share prices have fallen sharply.
Source for all market data: Bloomberg
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