Are emerging markets set for a new taper tantrum?

Having enjoyed a stellar 2017, emerging markets have not had things so easy since early May. A strengthening dollar and the possibility of faster than expected interest rate rises from the US Federal Reserve spooked investors and sparked a sell-off, while talk of a US-China trade war has hardly helped. Emerging market equities, bonds and currencies have all been in the line of fire, with Argentina and Turkey the hardest hit. 

Talk now is whether a stronger dollar is here to stay, and will it trigger a broader, more prolonged emerging market sell-off? Are we in line for a repeat of 2013’s ‘taper tantrum’, when fears over the Fed turning off the QE taps led to widespread market volatility, especially in emerging markets?

“Warren Buffet put it very clearly when he said: ‘When the tide pulls back, you can see who is swimming naked,’” explains Jorge Mariscal, CIO emerging markets at UBS Wealth Management. “Well, countries such as Argentina may not be completely naked, but they have very short briefs.”

It is the countries with vulnerabilities who have been hit hardest, he explains, whereas those who are in a better position have proved much more resilient. Asia, for example, has on the whole emerged relative unscathed from the market turmoil.

UBS sees opportunity in Asian equities, particularly in China, adding that Latin America looks more interesting on the debt side, especially sovereign debt.

This is by no means a crisis yet in emerging economies, insists Mr Mariscal, rather it is a market correction which is very much related to the strength of the dollar and the potential of a faster than expected raising of US rates.

For now, with emerging economies’ banking sectors looking sound, balance sheets in a much better situation than they were in the taper tantrum of 2013, and FX reserves back to pre-crisis levels for most countries, he believes most countries should be able to counter the turbulence through domestic responses and international co-operation. Argentina, for example, could well be helped out by the IMF and other bodies, predicts Mr Mariscal.

Yet, he does warn that if the dollar and rates continue to rise, things would become increasingly complicated for emerging economies. 

Different situation

Investors should not dismiss what has been going on, says Arnab Das, head of Emea and emerging market macro research at Invesco Fixed Income, but he believes the situation is nowhere near as bad as it was during the taper tantrum, and the market does not appear to be overly worried. The situation is very different now when compared to 2013, when markets were dealing with the eurozone crisis and significant concerns around China. 

“If you believe this is a transitory shock and that we are not heading down a much higher growth and inflation path for the US that diverges from the rest of the world, then we probably aren’t going to have accelerating rate hikes and the yield curve steepening a lot,” he says. 

Most investors are now more inclined to be bullish on emerging markets for their own merits, says Mr Das, because the adjustments they have made mean both the bottom up and top down situations look positive in a lot of countries. 

Last year was certainly a strong one for emerging markets, with the index rising more than 35 per cent, and that followed a strong second half in 2016. So it is not surprising that at some point after such strong returns, markets consolidate, believes John Malloy, co-head of emerging and frontier Markets at RWC Partners. Indeed, although it might mean some volatility, rates rising in the US should be positive for emerging and frontier markets because it would likely reflect stronger global growth, he says.

“Our view is that we are 18 months to two years into a bull market in emerging markets, and we really think it has another three to five years to run. Valuations are reasonable, earnings are good and the asset class is relatively under-owned, so you have buying power.”

Selectivity is key when it comes to investing in emerging markets, says Jaisal Pastakia, investment manager at Heartwood Investment Management. Argentina and Turkey’s recent troubles are a result of their poor management, he says, while Asia underwent structural reforms a decade or two ago and are now bearing the fruits of those.

“As a region, Asia’s equity markets have more depth and opportunities, and more consistent returns for investors. That is different from other parts of emerging markets.”

Asian companies often tend to have a domestic focus, enabling investors to play the rise of the domestic consumer theme. “Compare that to other regions, for example Eastern Europe, where equity markets and economies tend to be much more dependent on global, and particularly European, growth cycles,” explains Mr Pastakia.

Heartwood is overweight emerging markets, with a bias towards Asia, and within that it particularly likes India. It is particularly exposed to the country’s mid-cap companies, which are starting to see improved earnings growth.

“India has a workforce that is growing and powerful, but more important is the structural reform story. It has done a lot of work,” he says. “When you look at other emerging markets, many are still at stall speed when it comes to reforms. The people we speak to on the ground say there has been more work done in the last four years than in the previous 40.”

India also offers something different in an emerging market portfolio, as it tends to be more consumer driven, and less tech-focused that some other markets. Technology was a big driver or emerging market returns in 2017, but Mr Pastakia predicts returns will be less impressive this year.

The tactic employed by fund managers Artemis in emerging markets is to looking for companies with strong fundamentals which happen to be out of favour and therefore have attractive valuations.

“If you buy these at times of heightened risk or they fall out of favour then the upside can be considerable,” says Raheel Altaf, co-manager of the Artemis Global Emerging Markets fund.

He sees opportunities in Russia, which his fund is overweight. “Most of that comes from the large energy companies, for example Tatneft. The key driver for these companies is the improving oil price. Fundamentals look attractive and these happen to be some of the cheapest companies around the globe.” 

There are sanctions in place against certain Russia companies, but those not directly affected and which have strong fundamentals have also been sold off because of the political risk. “And we have taken the opportunity to buy these at cheaper prices,” he adds.

China dominant

It is impossible to formulate a view on emerging markets without taking account of China. And this is only going to increase with the inclusion of mainland-listed A-shares in the MSCI EM Index from June 1, which marks a significant step in China’s integration into global stockmarkets. 

Access to A-shares had been limited, with most foreign investors accessing Chinese companies through the Hong Kong stock exchange (H-shares) or on overseas exchanges. With China’s A-shares market the second largest equity market in the world by market cap, the country’s impact on global stockmarkets, and emerging market indices in particular, is only going to increase.

The Chinese economy seems to be in good health, believes David Stubbs, head of client investment strategy Emea at JP Morgan Private Bank. “Growth is good, retail sales are outstripping industrial production, and the authorities are getting more of a grip on the shadow banking and leverage issue.” 

So China looks set fair to do “reasonably well” over the next couple of years, which should provide a boost to emerging markets. “If we though China had significant issues, then that would be a turning point in our emerging market view,” he adds.

Not all agree

But not everyone is so optimistic as to the outlook for emerging markets. 

Emerging markets have already faced considerable capital outflows this year, says Taimur Baig, chief economist at DBS Bank, and this trend is unlikely to ease. “Conditions are ripe for further safe haven trades, which would leave some emerging markets vulnerable. We have already seen considerable stress in some Latin American economies, but a few Asian economies look susceptible as well.” 

He points to India, Indonesia, and Malaysia, which have large financing needs this year, and also face domestic economic and political constraints. 

Fund flows into emerging markets often reflect investors’ views on global growth, but that relationship is less important today that is has been at any time in the past, believes Devan Kaloo, global head of equities at Aberdeen Standard Investments. This is because the nature of the index has changed, with increasing importance of technology firms replacing the more traditional, and cyclical, energy and materials companies.

But the fact remains that emerging markets are dependent on foreign capital. “Foreign capital and foreign investors are the key drivers of these markets,” he says. “So global sentiment as to risk on/risk off is vital in determining whether these markets go higher. It is not just about fundamentals.”

Go private?

The medium- to long-term case for emerging markets tends to be understood by and excite high net worth investors, says Mr Stubbs at JP Morgan Private Bank, but he reports that conversations with clients often quickly shift away from public markets and into private markets. 

“When you think about it, emerging markets do scream for a private investment solution. You are talking about the increase in population, urbanisation consumers, industries with fragmented production sides, where a skilled private equity house can come in, optimise, do mergers, do vertical integrations and so forth.” 

The opportunities in private markets are often bigger and more in tune with the themes which are driving growth than those found in the public markets, he says.

“Yes, you have to lock up your money for a while, but a lot of our clients are able to do that,” adds Mr Stubbs. “And they show great interest in it.”   

Bargain bonds? 

Emerging market debt may have seen significant outflows recently, but strong fundamentals and cheaper valuations will likely encourage future inflows, provided the US dollar and Treasuries stabilise, believes Giulia Pellegrini, portfolio manager in BlackRock’s EM debt team. “Historically we have seen emerging market debt performing well in the context of gradual increases in global interest rates, which is what the Fed has been telegraphing it will do going forward.” 

She expects investors will see this as an opportunity to buy into the asset class, while becoming more discerning around country-specific issues, targeting those on a stronger economic footing and with lower short-term financing needs.

The recent pullback has produced the best entry point for more than two years in emerging market fixed income, claims Jan Dehn, head of research at Ashmore. “None of the factors behind the sell-off, which include profit-taking, rising US Treasury yields, trade war fears and geopolitical concerns, should change the generally strong outlook for EM external debt over the next few years,” he says.

There are inefficiencies in emerging market asset classes, says Mr Dehn, because many investors immediately sell their exposures every time a bout of risk aversion hits markets, regardless of the fundamental situation. “We think the asset class is cheap,” he adds.

Echoes of the past can be misleading, says Brett Diment, head of emerging market debt at Aberdeen Stndard, with fears over a second taper tantrum overblown. “We see the recent weakness as a buying opportunity. We have been selectively adding risk to our portfolios, confident that many attractive credits are ripe for reappraisal when the market overcomes its current bout of nerves.”

VIEW FROM MORNINGSTAR: Volatility presents opportunities

Emerging market equity returns remained just ahead of developed markets to the end of April 2018, albeit only just in positive territory in euro terms. 

This overall picture does, however, mask some changes in the relative fortunes of emerging markets, with strength in the early part of the year turning to relative weakness since late March, when emerging markets started to lag, as developed markets saw gains on the back of improving economic growth expectations. 

Views on US interest rate policy and the consequent strengthening of the dollar caused a sell-off in emerging market currencies, while there has also been some recent weakness at the stock level. Growth stocks that are a large part of the MSCI EM Index and were responsible for much of the gains seen in 2017, such as Taiwan Semiconductor and Tencent, have seen declines over this short period of time holding back index returns. 

Overall, however, emerging markets GDP growth remains above that of developed markets, particularly within Asia. Investment managers have seen signs of a broadening out of earnings growth within emerging markets sectors, and, although markets are expected to be more volatile, this should present opportunities for high quality active fund managers. 

The Fidelity Emerging Markets fund managed is Nick Price, who sits at the top of the considerable resources that feed into this product, including a team of more than 40 analysts who contribute research to regional portfolio managers. Mr Price will take input from these managers and analysts, but also conducts a lot of his own due diligence work. The resulting portfolio generally shows growth characteristics as well as quality aspects. 

JPM Emerging Markets Equity is run by Leon Eidelman. He makes good use of the 30-strong GEM and China analyst team, all of whom operate within a structured investment approach that produces a formal assessment of company quality and stock upside. The process is bottom-up and has a quality growth bias at the stock level, but at times the manager may take advantage of short term macro-weakness to initiate positions.

Simon Dorricott, associate director, Equity Strategies, Morningstar