Buying the dip: value in Emerging Markets

Whilst emerging market sentiment remains fragile, the 'crisis' narrative is largely an overreaction and, in general, economic fundamentals are resilient.

Since the beginning of April, emerging markets have suffered a widespread selloff, triggered by a spike in U.S. Treasury yields. This led to a succession of USD inflows, as international investors became more incentivised to buy US bonds for the improved returns, at the expense of their EM positions.

While the selloff has been widely felt, the most impacted EM economies have been Argentina and Turkey, who have so far experienced currency depreciations of 25% and 15% respectively. Broadly, the most susceptible EM economies to USD headwinds have been those with: (1) current account deficits; (2) large USD leverage and; (3) high external funding needs. However, tarnished by the same brush, a number of economies with solid fundamentals have also suffered by contagion.

Shown in the chart below is an evolution of EM currencies (left axis) against the USD (right axis) over the last 18 months:

Evolution of Emerging Markets Currencies graph

Source: Bloomberg - data to 08.06.18

Whilst some of the more timid commentators have labelled the current selloff a ‘crisis’ – perhaps still haunted by painful memories of 1997 and, to a lesser extent, 2015 – we consider this an overreaction and thus are not pushing the proverbial panic-button. On balance, we see the outlook for EM as broadly positive and consider macro factors supportive of a near term recovery.

Due to EM acting as an umbrella term for a number of fast growing economies, a contagion risk exists whereby the macro imbalances and political uncertainties at individual country levels can cause a domino effect to the wider EM pool. However, the EM bracket is a collective of around 50 countries with varied economic fundamentals. As such, we view the ubiquitous EM vs DM dichotomy as becoming less and less relevant. In reality, there are significant differences between emerging countries in terms of the economic environment, monetary policy, political situation, and regulatory conditions.

Fundamentally, developing economies are on balance better positioned than they were in the 1997 Asian crisis; with lower inflation levels, external leverage down 10% and stronger balance of payments. Whilst political uncertainty and external shocks can more than override fundamentals in the short-term, these factors should enable better central bank management of external shocks.

The below chart shows the improvement in external leverage, measured by collective EM external debt as a percentage of GDP (left axis) alongside EM inflation (right axis), which has also fallen, since the 1997 Asian crisis:

Source: Bloomberg, Waverton - data to 08.06.18

Whilst USD strength remains a headwind in the weeks ahead, we expect this to fade over the remainder of 2018 as EM economic fundamentals show resilience and the risk-off sentiment subdues. Additionally, we view the recent EM selloff as being partially overdone and, selectively, some current valuations may now present good value.

In conjunction with this view, the Waverton Global Strategic Bond Fund, which has exposure to EM debt, has been increasing its positions in India and Brazil, where we think yields are attractive and the cheapened currencies have the potential to recover.

By James Carter


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