There’s no denying the fact that emerging markets (EM) have faced a perfect storm of external risks this year. The rising dollar, the Federal Reserve’s commitment to raising rates, the looming threat of a US-China influenced global trade war alongside domestic political issues have hit several countries hard, especially those with large current account deficits, souring investor sentiment towards the asset class.
Two countries that have come to symbolize the idea of an EM crisis are Turkey and Argentina, both of which have seen their currencies plummet and the value of their USD denominated bonds crash. They are now the infamous sick-men of emerging markets and every headline warns of contagion.
Not surprisingly then, what has happened in these two countries is arguably influencing investor sentiment towards the entire emerging markets in 2018.
However, EM isn’t a party of two and investors shouldn’t paint the whole asset class with the same brush. In fact, our investible universe encompasses close to 60 countries, many of which have a stronger focus on reform today than ever before.
For example, rate hikes have already been seen across Indonesia and India this year, whilst expectations of further increases in Russia are likely to play out. Meanwhile, several central banks across emerging markets are taking a more proactive stance – even though inflation expectations remain well anchored – as they look to protect their economies from negative investor sentiment. For dedicated investors, it’s not only reassuring to see this level of sophistication across many EM central banks, but also the fact they have very clearly learned from previous mistakes.
Looking beyond the panic
The events in Turkey and Argentina, rather than denting the EMD market, have instead made emerging market debt (EMD) as an asset class more attractive than at any point I can remember over the past two years. The reasons for this are two-fold.
First, due to the Fed’s tightening cycle, investors have almost synchronously bought bonds with very short-term maturities. For us, this has meant one thing: more opportunities in the long part of the yield curve. As investors pile into short duration bonds, contrarian investors are being compensated to extend duration.
Second, the volatility we are experiencing has resulted in attractive valuations and thus entry points. In 2017, investor sentiment towards EM was positive, fuelled by a combination of synchronized global growth and strong local demand, and inflows to the market were near record highs.
Much of these flows came from non-dedicated EM investors however, and as we see some of these flows reverse it has created opportunities, there are many instances where bonds are mispriced due to the indiscriminate sell-off from the same non-dedicated investors fleeing the market. Spreads YTD have widened from the tights of 250 bps at the beginning of the year to 380 bps as of September 2018. We have thus been able to improve the quality of our holdings, but without having to sacrifice yield.
The case for Asia and the Middle East
In the short term however, we do remain cautious given the external threats mentioned, and are therefore focusing our attention on low beta countries such as Kuwait and UAE, which has very strong macro indicators.
Alongside these, we are also positive on some Asian countries and regions such as Singapore, Korea and Hong Kong given their resiliency over external challenges. Growth is still expected to be robust, according to the Asian Development Bank, and at the end of 2018 growth in developing Asia is expected at 6 percent and 6.5 percent excluding the high-income newly industrialized economies. However, for us the most relevant driver of this growth is still a strong domestic demand, given inflation expectations are well anchored.
On top of this, we are also positive on Asia as the region seems to have learned much from the crises at the end of the last century. Not only has it diversified its funding base (over the last two decades we have seen the emergence of domestic savings institutions making them bid holders of local debt) but also in running more stability-oriented policies that should keep the region in a stronger footing if the global environment deteriorates.
Ultimately, there are several countries in emerging markets that are facing crises. However, as non-dedicated investors flee the asset class in general this creates opportunities for dedicated investors that can look beyond the noise. For every Turkey and Argentina, there are a handful of other countries in the asset class that we think still provide excellent opportunities.
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