Argentina's peso currency is at its weakest levels ever against the dollar, despite eye-watering interest rate hikes designed to stop portfolio capital flowing out from the third-largest country in Latin America as investors bail out of its assets.
On the brink of a full-blown currency crisis, the country is digging into its reserves to prop up its troubled currency and is in talks with the IMF about a potential programme of support, highlighting how vulnerable many emerging markets remain when global liquidity conditions change.
Turkey is also staring down the barrel of a financial crisis as the lira plummets.
So as US interest rates continue going up and the Federal Reserve slowly withdraws liquidity from the financial system by selling bonds from its bloated balance sheet, should investors reduce their exposure to emerging markets generally and seek returns elsewhere?
And which countries are expected to be the most resilient and which ones have the largest country risks?
We asked six emerging market experts from four fund houses, one risk consultancy and one market maker for their views.
The following transcripts have been edited for clarity and brevity.
Olivier d’Assier, head of applied research for Asia
Emerging markets are in a two-tiered situation right now: Some are seen as riskier (e.g. China, Brazil, Turkey, Indonesia, India, Russia), and some are seen as less risky than even the US market (South Korea, Taiwan, Mexico, Malaysia, Thailand, Philippines). But what you also see is that in some cases, this higher risk was rewarded with higher returns (i.e. China and Brazil), while some of the lower-risk countries saw negative returns (i.e. Thailand, Malaysia, Mexico).
At the same time, low risk does not mean better returns. Investors are clearly discriminating when it comes to emerging markets right now. What you want to avoid are the higher-risk, lower return countries like Argentina (off the chart!), Indonesia, and The Philippines. As you can see from Axioma’s emerging market risk monitor, developed markets are much more homogeneous than emerging markets. Currency risk and currency hedging costs are also being factored into emerging market investment decisions, and with a rising dollar hedging is not cheap.
Although emerging market risk is currently higher than at the start of the year, it is off the highs we saw in February (ditto for correlations). So the risk picture is mixed but, overall, not bad enough for people to completely pull out. Some rebalancing seems appropriate, focusing on countries with current account surpluses and out of Mr Trump’s Twitter target zone. But other than that emerging markets benefit from strong economies in the developed world, so as long as the investor consensus remains positive on global GDP growth, and should remain part of the portfolio.
Sean Taylor, chief investment officer for Asia Pacific
The last few months have been tricky for emerging market currencies since the pick-up of the US dollar. However most emerging market currencies are trading as we would expect, with current account surplus economies and better politics outperforming those with more difficult current accounts and uncertain politics. Turkey and Argentina are isolated incidents. Argentina is not included in the MSCI EM index overall and Turkey has a small representation.
In Asia, India has not done too well given the rise of commodities and oil prices, whilst Malaysia’s new government has caused some political uncertainty, which is seen in the ringgit – however higher oil prices for Malaysia will help bolster their current account.
For China the renminbi has strengthened since the beginning of the year while the Korean won has mostly been stable during the latest geopolitical tensions. Russia, however, has seen a depreciation in its currency post sanctions.
Current account deficit emerging market countries and those with high US dollar debt levels are being impacted through their domestic currencies and/or foreign reserves, although rising US rates have been well flagged. If easing financial conditions tighten more sharply than expected, emerging markets debt could come under pressure. DWS expects two further 25 basis point hikes by the Fed by the end of the year with US 10-year yields of 3.25% by March 2019.
However, offsetting the potential for capital flight remains a solid global growth backdrop for emerging markets and Asia, which are in a better position to adjust to changes in US and Chinese policy. Investing in emerging markets has, therefore, been selective, avoiding those most vulnerable economies with deteriorating current account deficits and uncertain politics (Indonesia, Argentina, Philippines, Turkey, Malaysia) and under pressure to raise rates (Indonesia, Philippines), as well as those under potential trade/sanctions (Mexico, Russia) – while taking advantage of the rise in commodities, energy and oil prices where we have been sectorally overweight.
In aggregate Asian currencies are almost unchanged year-to-date versus the US dollar, if weighted by market cap within the MSCI EM index. Assuming that most of the US dollar rally and US bond yield increase have been seen, further pressure on emerging market equities should reside and help to refocus investors on strong Asian macro and corporate fundamentals.
In the short-term, though, risky assets are entering a seasonally weak period. Furthermore, we notice that globally US trade policy, Italy’s new anti-EU rhetoric, and select emerging market currency weaknesses have all caused increased uncertainty. This might limit near-term market upside. All three aspects require close monitoring. While an outcome is difficult to predict, our base case assumes no escalation of these issues and an eventual positive resolution triggering a sentiment relieve.
Dwyfor Evans, managing director and head of Asia-Pacific macro strategy
State Street Global Markets
Investors need to consider two specific factors for their emerging markets exposure: US yields and the US dollar.
Over a long-term horizon, there is a strongly positive correlation between emerging market assets and US yields, as rising yields signify stronger economic conditions. This is palpably good for emerging markets. However, if higher US yields lead to a stronger dollar, then the picture changes. US dollar strength is nearly always a negative factor for emerging market assets and that is the environment that we are currently in (a contrast to 2017).
This being the case, and as we continue to view contagion risks as contained, we separate emerging markets exposure between markets vulnerable to higher debt-servicing costs and rising commodity prices (e.g. India, Indonesia and Turkey) against those where commodity prices are supportive and rising yields are, at the margins, more manageable (e.g. Malaysia and Colombia). The Malaysian ringgit remains the regional standout, in our view: currency fundamentals – higher commodity prices, trade surplus, attractive valuations and high absolute rates – should still prove supportive on a relative basis to regional peers.
On a broader basis, key risks are unlikely to be resolved any time soon: eurozone political risks, the on-off scenario regarding North Korea, on-going trade negotiations. In the main, these look likely to weigh on sentiment near-term, but the capricious nature of political risks, in particular, are prompting investors to de-risk to some degree pending a return to more favourable conditions, if they reappear.
Lee Porter, head of Asia Pacific
Asian emerging markets remain unique but robust overall. Whilst emerging markets can undoubtedly be vulnerable to market volatility, across Asia they continue to experience broad growth in terms of year-on-year trading activity (2017 vs 2018 YTD).
Each of these markets are unique and looking at them in more detail in terms of equity trading volumes through Liquidnet’s platform we can see that the largest continues to be India, with growth of 20% year-on-year, alongside our second-biggest emerging market, Indonesia, which we have seen as flat thus far this year. In Malaysia and Thailand we have seen 100%+ and 50% growth year-on-year.
We are also increasingly seeing the consistent rise of block trading across the Asian emerging market region – as investors seek greater certainty in market execution, with wide spreads and shallow liquidity. We expect the increased search for block trades in emerging markets will continue.
In terms of the overall equity market, it is evident that there are net year-to-date foreign investment outflows in Indonesia ($2.9 billion), Philippines ($936 million) and Thailand ($3.7 billion) – indicative of the current hesitancy in these markets.
The Southeast Asian region as a whole should be healthy in the near future as long as the Fed’s rate hike trajectory is well communicated and anticipated. The region is expected to have robust GDP growth with contained inflation, so investment opportunities should still be plenty. Outflows are natural given the interest rate gap, but we have seen Asean central bankers close that gap recently.
Luc D’hooge, head of emerging markets for fixed income
Vontobel Asset Management
Fears of rising US interest rates and currency volatility play a sentiment effect and are not a fundamental game changer. In fact, all the three pillars – fundamentals, technical and valuations – are looking healthy. Therefore, now may be the right moment to step in or at least maintain exposure rather than capitulate.
When investors are scared, they tend to exaggerate the negative and downplay the positive. This is what is happening now. Certain countries clearly experience volatility on the currency level, like Argentina, and then everything else is sold ‘in sympathy’.
There is a belief among some investors that there is a direct relationship between rising long end rates and widening emerging market spreads as real money repatriates assets home from emerging markets to place at higher yields locally, where they feel safe.
History shows that this is not always the case. We made a linear regression of EMBI Global Diversified spreads against 10-year US Treasuries over the past decade, there are some outliers, but the message is clear: higher risk-free rates generally mean tighter emerging market sovereign credit spreads. In other words, when risk free rates rise, emerging market yields do not increase as much. As a result, emerging markets debt tends to outperform risk-free assets.
We remain constructive and find good investments in the quasi-sovereign bond sector. We believe that idiosyncratic stories like Mexico century bonds and Indonesian bonds in euros offer value. We like Argentina, Ivory Coast and Tunisia.
As contrarian investors, we find attractive investments when other investors are worried. Market turmoil creates severe mispricings, which we see as opportunities. We see Argentina as being on the right path after labour and economic reforms. We expect the situation to improve and upgrades in the coming months are possible, but nevertheless the situation is difficult there. Of course, that offers opportunities on the other side.
Ernest Yeung, portfolio manager for emerging markets value equity fund
T. Rowe Price
The recent volatility will not break the emerging market investment story. We see it as a mid-cycle correction, and market weakness often presents buying opportunities.
T. Rowe Price’s Emerging Markets Value Stock Strategy tends to be contrarian. We missed the rally in Argentina and intentionally avoided the popular frontier markets that experienced a lot of inflows in the last 1-2 years. We focus more on the large emerging market countries.
The larger emerging market countries are in much better shape today than any time in the last five years. Most of them are recovering from an economic slowdown, which ended in the first half of 2016.
Most emerging market countries are in the early-mid stage of economic recovery and this recovery path is unlikely to be derailed by US interest rates or other headline news like a trade war.
North Asia, such as China, Korea and Taiwan, typically will have less FX volatility than Latin America or Emerging Europe. We also like the Middle East – attractive valuations, US dollar pegs, under-owned by most emerging market investors.
We continue to like financials as a sector. Some will benefit from US rate hikes but most of them have attractive bottom-up stories supported by compelling valuations.