Buying back into emerging markets
After almost a year of selling emerging markets, investors seem to be returning in force. The latest to turn positive on the asset class is asset and wealth manager Pictet Group (AUM: 265 billion pounds) which said on Tuesday its asset management division (clarifies division of Pictet) was starting to build positions on emerging equities and local currency debt. It has an overweight position on the latter for the first time since it went underweight last July.
Local emerging debt has been out of favour with investors because of how volatile currencies have been since last May, For an investor who is funding an emerging market investments from dollars or euros, a fast-falling rand can wipe out any gains he makes on a South African bond. But the rand and its peers such as the Turkish lira, Indian rupee, Indonesian rupiah and Brazilan real — at the forefront of last year’s selloff — have stabilised from the lows hit in recent months. According to Pictet Asset Management:
Valuations of emerging market currencies have fallen to a point where they are now starkly at odds with such economies’ fundamentals. Emerging currencies are, on average, trading at almost two standard deviations below their equilibrium level (which takes into account a country’s net foreign asset holdings, inflation rate and its relative productivity).
What’s more, interest rates in all these countries have risen since the selloff kicked off last May, in some cases by hundreds of basis points. That makes running short positions on emerging currencies and local debt too costly, analysts say. What’s also helping is the sharp volatility decline across broader currency markets, with Reuters data showing one-month euro/dollar implied volatility near its lowest since the third quarter of 2007. That has helped revive carry trades — the practice of selling low-yield currencies in favour of higher-yield assets Low volatility and high carry – that’s a great backdrop for emerging markets. No wonder that last week saw cash return to emerging debt funds after first quarter outflows of over $17 billion. Pictet again:
Local currency bond yields have climbed in recent months – quite steeply in some cases – hence, the asset class has acquired some extremely positive characteristics. Such yields are now among the highest of all global fixed income classes, yet their duration is among the lowest. In a period likely to see higher U.S. bond yields, that makes for an attractive combination.
What of emerging equities? As we wrote here, banks have started to root for a revival, based on beaten-down valuations and a tentative recovery in economic growth and improving trade data. Societe Generale analysts note that the quantum outflow from EM equity funds in the past year has been the biggest in 10 years. Historically, EM assets have performed well subsequent to such outflow, they say, pointing to the following graphic:
The weak spot for this trade, however, is that economies remain weak, especially as many central banks, from India to Turkey, have put in place growth-crimping rate rises. Company earnings are showing little sign of recovery in most developing countries — Morgan Stanley estimates that companies in the MSCI emerging markets index have missed earnings forecasts 8 out of the past 10 quarters. Net income mised forecasts by around 5 percent across emerging markets on average, Morgan Stanley says.
Pictet asset managers remain relatively unenthusiastic about equities, with a neutral position, noting geo-political risks in Russia and question marks over U.S. and Chinese growth. All these, according to them, will put a dampener on corporate profits.