Smoke and glimmers

IFR IMF/World Bank Report 2014
11 min read

After the tapering-driven fire sale of emerging market assets in 2013, EM sentiment has now improved and many investors admit that positive economic fundamentals had been overlooked last year. But some previously held assumptions need a rethink and the risks must be carefully managed.

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A quick glance at the headlines would lead to the natural conclusion that now is not the best possible time to invest in emerging markets. Escalating tensions in Russia and the Middle East, coupled with political changes in a host of key emerging markets, including Brazil, India and Indonesia, have ramped up the geopolitical risks.

Meanwhile, regional blocs of countries that had previously moved in tandem have begun to go their separate ways, making investment decisions more complex.

But scratch the surface and many investors are quietly bullish on emerging markets. The tailspin caused by last year’s announcement of the US Federal Reserve’s plans to scale back quantitative easing, which led to a massive sell-off in EM assets, is now a distant memory, and there is a widespread belief that many emerging market assets now have better prospects than developed markets.

“We have seen an inflection point in emerging markets this year and fundamentals are now coming back. EM assets will not trade in a single direction going forward – there is substantial alpha to be made on the dispersion between individual countries’ fundamental and idiosyncratic risk. In our team, we are taking a relative value approach to capture the best investment opportunities,” said Sergio Trigo Paz, head of emerging markets fixed income at BlackRock.

One of the challenges inherent in emerging markets, which has been particularly prevalent over the past year, is to distinguish clearly between economic fundamentals and price volatility. It was the frenzied reaction to the initial talk of QE tapering in May 2013 that first led to major price movements, but fundamentals remained, for the most part, fairly resilient.

Victims of the price volatility have spanned multiple countries and asset classes, but currencies are a case in point. The Indian rupee, for example, weakened sharply in the aftermath of the tapering announcement, losing more than 24% of its value against the US dollar between May and September, while the Indonesian rupiah lost nearly 20% of its value during the same period, according to data from Thomson Reuters. More recently, political tensions in Russia and Turkey led to sharp moves in the rouble and the lira this year.


But the violent moves and pessimistic voices that were so widespread in emerging markets during the second half of 2013 turned out, for the most part, to be inconsistent with economic fundamentals. China, for example, which was beset by concerns over a “hard landing” for its economy, saw GDP growth of 7.7% in 2013, according to the World Bank. GDP in India was 5.0%, and in Indonesia it was 5.8%.

When compared with much more anaemic growth in developed markets still struggling to emerge from the economic downturn – 0.4% GDP growth in Germany, 1.7% in the UK and 1.9% in the US – it is easy to see why EM have become so attractive for investors. But the negative assumptions driven by price volatility can be a problem for fund managers looking to attract risk-averse investors.

“Emerging markets are actually one of the most inefficient asset classes on the planet, because prices often move completely away from the underlying fundamentals. Despite all the doomsday predictions, what happened last year was really just a technical adjustment in prices, but EM fundamentals actually remained remarkably robust,” said Jan Dehn, head of research at Ashmore, a London-based EM investment management firm.

The sell-off in EM assets cheapened prices dramatically and meant that when sentiment did begin to improve earlier this year, investors were able to take advantage of very undervalued assets. Amid weaker than expected growth in developed markets and concerns over inflation in the eurozone, the intrinsic value of EM has only become more attractive as the year has progressed.

“Emerging markets are actually one of the most inefficient asset classes on the planet, because prices often move completely away from the underlying fundamentals”

“Last year, we saw a lot of money go into developed market equities because the growth outlook looked much better and the valuations were still appealing. However, we now see money increasingly going back to EM, where the perception of fundamentals has improved, even though in absolute terms they have only improved marginally since last year,” said Koon Chow, head of EM strategy for fixed income, currencies and commodities at Barclays.

Changing faces

While it may be understandable to consider EM as one amorphous group of countries, such an approach loses sight of the nuances between different markets and regions. Even within regions, assumptions about particular blocs of countries that might previously have guided investment decisions are increasingly breaking down, requiring investors to be much more selective when choosing where to put their money.

The BRICs group is one example of an EM grouping that now looks less relevant than it once did. The acronym, which was coined more than a decade ago by economist Jim O’Neill to denote the similar growth potential of Brazil, Russia, India and China, may have been a helpful tool to educate the investment world at the time, but as the economic path of the four countries diverges, some believe it is now much less constructive.

“It is becoming more and more difficult to say generic things about the emerging world, and it’s now much more about looking at the specific risks and opportunities of these different countries rather than just buying an acronym. I think that’s a very positive development and a sign that EM are maturing,” said Marcus Svedberg, Geneva-based chief economist at EM-focused investment management firm East Capital.

‘Fragile Frugal Five’

Even the “Fragile Five”, a grouping defined as recently as last year by Morgan Stanley to identify Indonesia, South Africa, Brazil, Turkey and India as the countries most at risk from the start of tapering, is now deemed by some to be outdated. While all five countries ran large current account deficits at the time, making them very reliant on external financing, some have outperformed expectations since tapering began.

“The Fragile Five designation didn’t last for very long because some of those countries, such as Indonesia, have actually managed to produce a current account surplus within six months, and some people now label them the Frugal Five,” said Ashmore’s Dehn.

The break-up of such groupings might be a sign of maturity in EM, but it also means the buyside now has a somewhat tougher job identifying where to invest. And while risk aversion last year may well have been excessive, there are still risks that need to be carefully managed, particularly as the number of countries within the EM universe grows.

James Wood-Collins, chief executive of Record Currency Management, has constructed his product offering around a long-term view that EM currencies will appreciate against developed market currencies as the productivity and price levels in EM catch up with the developed world. That strategy covers 19 individual countries, but there is a constant need to be aware of the risks that could cause exceptions to the house view.

“We have a subgroup of our investment committee whose responsibility it is to monitor those 19 countries on an ongoing basis and exclude currencies if they think the risk criteria are unlikely to be met. That discretionary override process is critical when investing in EM and one has to have people paying close attention to macro, political, financial, military and geopolitical issues on the ground, with the willingness to make decisions when necessary,” Wood-Collins explained.


Wood-Collins believes currencies offer the best opportunity to generate returns from EM as there is greater liquidity in the FX market, so investors can choose which countries to invest in more freely than if they were to use the equity or bond markets. FX products such as non-deliverable forwards also offer greater flexibility and are generally cheaper than other asset classes, he added.

“We think there is a strong case for investors to look at EM currency as a distinct rewarded risk opportunity in its own right. This is particularly true in an environment when interest rates are expected to rise and there are strong arguments for looking at currencies as an alternative to debt,” said Wood-Collins.

The debt market could be more negatively affected by geopolitical risks than the FX market, with bankers reporting a decline in activity in key markets such as Russia. Cecile Camilli, head of debt capital markets origination for Central and Eastern Europe, the Middle East and Africa at Societe Generale, described the outlook for the rest of the year as “mixed”.

“If we look at issuance in the year to-date, we haven’t yet seen a significant decline – there has been just over US$100bn of issuance across CEEMEA. But Russia and the CIS, which was the largest provider in the region, has been declining to reach an almost total absence from the market, and it’s not clear whether it will revive before year-end,” said Camilli.

Looking forward to the fourth quarter, as growth expectations in many developed markets continue to disappoint and betting on the timing of interest rate hikes intensifies, EM offer attractive opportunities for yield-hungry investors. Their challenge is to evaluate the potential value of countries and products on a case-by-case basis, paying due attention to the potential impact of geopolitical risks.

“Event risk will continue to play a big role in EM: we still have the Brazilian elections in October; important political changes in Turkey; the deterioration of the situation in Russia; and the developments in Iraq. All of these risks are quite powerful and could have contagion effects to other markets,” said Chow at Barclays.

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Smoke and glimmers
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