Global Investing

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.

Will Lithuania fly like a hawk or a dove at the ECB?

No one will really know how Lithuania will impact European Central Bank monetary policy until the country gets a seat at the table. That is expected to happen in 2015, provided the last of the three Baltic nations meets the criteria to become the euro zone’s 19th member. We’ll all find out in early June.

The ECB’s monetary policy remains at its loosest (main refinancing rate is just 0.25 pct) since the bank assumed central banking responsibilities for the euro area 15 years ago. My Frankfurt-based colleague, Eva Taylor, explained earlier this month that the addition of Lithuania will change the voting patterns of the ECB, curbing smaller members’ perceived influence and giving more weight to the center.

Here in New York, Lithuania’s Economy Minister Evaldas Gustas, along with Mantas Nocius, who heads up the ministry’s enterprise department, presented investors with an overview of the economy. When asked if Bank of Lithuania Governor Vitas Vasiliauskas would be a hawk or a dove should Lithuania join the euro zone in 2015, the answer, at least from Nocius, was as sharp as a claw.

Market cap of EM debt indices still rising

It wasn’t a good year for emerging market bonds, with all three main debt benchmarks posting negative returns for the first time since 2008. But the benchmark indices run by JPMorgan nevertheless saw a modest increase in market capitalisation, and assets of the funds that benchmark to these indices also rose.

JPMorgan says its index family — comprising EMBI Global dollar bond indices, the CEMBI group listing corporate debt and the GBI-EM index of local currency emerging bonds — ended 2013 with a combined market cap of $2.8 trillion, a 2 percent increase from end-2012. Take a look at the following graphic which shows the rise in the market cap since 2001:

Last year’s rise was clearly much slower than during previous years.  It was driven mainly by the boom in corporate bonds, which witnessed record $350 billion-plus issuance last year, taking the market cap of the CEMBI to $716 billion compared to $620 billion at the end of 2012, JPM said.

Waiting for current account improvement in Turkey

The fall in Turkey’s lira to record lows is raising jitters among foreign investors who will have lost a good deal of money on the currency side of their stock and bond investments.  They are also worrying about the response of the central bank, which has effectively ruled out large rate hikes to stabilise the currency. But can the 20 percent lira depreciation seen since May 2013 help correct the country’s balance of payments gap?

Turkey’s current account deficit is its Achilles heel . Without a large domestic savings pool, that deficit tends to blow out whenever growth quickens and the lira strengthens . That leaves the country highly vulnerable to a withdrawal of foreign capital. Take a look at the following graphic (click on it to enlarge) :

In theory, a weaker Turkish lira should help cut the deficit which has expanded to over 7 percent of GDP.  Let us compare the picture with 2008 when the lira plunged around 25 percent against the dollar in the wake of the Lehman crisis. At the time the deficit was not far short of current levels at around 6 percent of GDP.  By September 2009 though, this gap had shrunk by two-thirds to around 2 percent of GDP.

The hryvnia is all right

The fate of Ukraine’s hryvnia currency hangs by a thread. Will that thread break?

The hryvnia’s crawling peg has so far held as the central bank has dipped steadily into its reserves to support it. But the reserves are dwindling and political unrest is growing. Forwards markets are therefore betting on quite a sizeable depreciation  (See graphic below from brokerage Exotix).

 

The thing to remember is that the key to avoiding a messy devaluation lies not with the central bank but with a country’s households. As countless emerging market crises over decades have shown, currency crises occur when people lose trust in their currency and leadership, withdraw their savings from banks and convert them into hard currency.  That is something no central bank can fight. Now Ukraine’s households hold over $50 billion in bank deposits, according to calculations by Exotix. Of this a third is in hard currency (that’s without counting deposits by companies).  But despite all the ruckus there is no sign of long queues outside banks or currency exchange points, scenes familiar to emerging market watchers.

Why did the market get the Fed and ECB so wrong?

To err once is unfortunate. To err twice looks like carelessness.
One of the great mysteries of 2013 will surely be how economists, investors and market participants of all stripes so spectacularly misread two of the biggest central bank policy set-pieces of the year.
The first was the Federal Reserve’s decision in September not to begin withdrawing its $85 billion-a-month bond-buying stimulus, the second was the European Central Bank’s decision in November to cut interest rates to a fresh low of just 0.25 percent.
The Fed’s decision on Sept. 18 not to “taper” stunned markets. The 10-year Treasury yield recorded its biggest one-day fall in almost two years, and the prospect of continued stimulus has since propelled Wall Street to fresh record highs. (See graphic, click to enlarge)


A Reuters poll on Sept. 9 showed that 49 of 69 economists expected the Fed to taper the following week, a consensus reached after Ben Bernanke said on May 22 that withdrawal of stimulus could start at one of “the next few meetings”.
But tapering was – and still is – always dependent on the data. And throughout this year, the Bernanke-Yellen-Dudley triumvirate has consistently noted that the labour market is extremely weak and the recovery uncertain.
Going into the Sept. 18 policy meeting unemployment was above 7 percent and the Fed’s preferred measure of inflation was well below target, barely more than 1 percent.
Plus, a simple read of the Fed’s statutory mandate of achieving “maximum employment, stable prices, and moderate long-term interest rates” should have dispelled the notion a reduction in stimulus was imminent.
“People just didn’t want to listen. They just didn’t believe that they have to follow the data. They’ve not been listening, and it’s really hard to understand why,” said David Blanchflower, professor of economics at Dartmouth College in the United States and former policymaker at the Bank of England.
It was a similar story with the ECB’s interest rate cut on Nov. 7 which only three leading banks – UBS, RBS and Bank of America-Merrill Lynch – correctly predicted.
These three institutions quickly adjusted their forecasts after shock figures on October 31 showed euro zone inflation plunging to a four-year low of 0.7 percent, triggering the euro’s biggest one-day fall in over six months.


By anyone’s measure, 0.7 percent falls some way short of the “below, but close to, 2% over the medium term” inflation rate stipulated in the ECB’s mandate.
So why did the highly paid experts get it so wrong again?
Herd mentality might have something to do with it.
“It’s great if you’re all right together, and equally great if you’re all wrong together,” Blanchflower said.
It’s like a fund manager who loses 20 percent in a year where the market is down 21 percent. He might have screwed up, but so did everyone else. And technically, he outperformed the market so can claim to have “earned” his large fees.
To be fair, some of the central banks’ communication this year hasn’t been quite as clear as intended. See Bernanke’s comments on May 22 and recent confusion over the Bank of England’s “forward guidance”.
If one of the aims of forward guidance is to avoid volatility and variance of opinion about the trajectory of policy, then this kind of spectacular misread is an indictment of forward guidance.
In addition, since Draghi’s famous “whatever it takes” speech in July last year, the ECB has always had the potential to catch the market off-guard.
But maybe we shouldn’t be so charitable, and the market’s wailing at being misled by the central banks should be taken on board but ultimately ignored. The tail should not wag the dog.
“The Fed can’t be or shouldn’t be a prisoner of the markets,” we were reminded on Thursday, by none other than Fed Chair-elect Janet Yellen.

Turkish savers hang onto dollars

As in many countries with memories of hyperinflation and currency collapse, Turkey’s middle class have tended to hold at least part of their savings in hard currency. But unlike in Russia and Argentina, Turkish savers’ propensity to save in dollars has on occasion proved helpful to companies and the central bank. That’s because many Turks, rather than just accumulating dollars, have evolved into savvy players of exchange rate swings and often use sharp falls in the lira to sell their dollars and buy back the local currency. Hence Turks’ hard currency bank deposits, estimated at between $70-$100 billion –  on a par with central bank reserves — have acted as a buffer of sorts, stabilising the lira when it falls past a certain level.

But back in 2011, when the lira was in the eye of another emerging markets storm, we noticed how some Turks had become strangely reluctant to sell dollars. And during this year’s bout of lira weakness too, Turkish savers have not stepped up to help out the central bank, research by Barclays finds. Instead they are accumulating dollars — “rather than being contrarian, their behaviour now seems aligned with global capital flows,” Barclays  analysts write. While the lira has weakened to record lows this year, data from UBS shows that the dollarisation ratio, the percentage of bank deposits in foreign currency, has actually crept up to 37.6 percent from 34.5 percent at the start of the year. Here’s a Barclays graphic that illustrates the shift.

What are the reasons for the turnaround? In the past, those selling dollars to buy back cheap lira could be confident they would not be out of pocket because the central bank would support the lira with higher interest rates.  But ever since end-2010, when the bank embarked on a policy of determinedly keeping interest rates low, they no longer have this assurance. Barclays write:

Emerging equities: out of the doghouse

Emerging stocks, in the doghouse for months and months, haven’t done too badly of late. The main EM index,  has rallied more than 11 percent since its end-August troughs, outgunning the S&P 500′s 3 percent rise in this period. Bank of America/Merrill Lynch strategist Michael Hartnett reminds us of the extreme underweight positioning in emerging stocks last month, as revealed by his bank’s monthly investor survey.  Anyone putting on a long EM-short UK equities trade back then would have been in the money with returns of 540 basis points, he says.

Undoubtedly, the postponement of the Fed taper is the main reason for the rally.  Another big inducement is that valuations look very cheap (forward P/E is around 9.9 versus a 10-year average of 10.8) .

According to Mouhammed Choukeir, CIO , Kleinwort Benson:

Looking at valuations we think emerging markets are in an attractively valued zone, hence we think it’s a good investment. EMs are in negative momentum trend but have good valuations. We’re sitting on the positions we’ve built but if it hits a positive (momentum) trend we will add on it…. You wait for value and value will translate into returns over time.

Bernanke Put for emerging markets? Not really

The Fed’s unexpectedly dovish position last week has sparked a rally in emerging markets — not only did the U.S. central bank’s all-powerful boss Ben Bernanke keep his $85 billion-a-month money printing programme in place, he also mentioned emerging markets in his post-meeting news conference, noting the potential impact of Fed policy on the developing world. All that, along with the likelihood of the dovish Janet Yellen succeeding Bernanke was described by Commerzbank analysts as “a triple whammy for EM.” A positive triple whammy, presumably.

Now it may be going too far to conclude there is some kind of Bernanke Put for emerging markets of the sort the U.S. stock market is said to enjoy — the assumption, dating back to Alan Greenspan’s days, that things cant go too wrong for markets because the Fed boss will wade in with lower rates to right things. But the fact remains that global pressure on the Fed has been mounting to avoid any kind of violent disruption to the flow of cheap money — remember the cacophony at this month’s G20 summit? Second, the spike in U.S. yields may have been the main motivation for standing pat but the Treasury selloff was at least partly driven by emerging central banks which have needed to dip into their reserve stash to defend their own currencies. According to IMF estimates, developing countries hold some $3.5 trillion worth of Treasuries, of which just under half is in China. (See here for my colleague Mike Dolan’s June 12 article on the EM-Fed linkages)

David Spegel, head of emerging debt at ING Bank in New York says the decision reflects “an appreciation for today’s globalised world”:

A boost for cheap emerging equities. So will they bite?

Emerging stocks have rallied 3 percent today after the Fed’s startling decision to leave its $85 billion-a month money-printing in place, and some markets such as Turkey are up more than 7 percent. With the first Fed hike now expected to come in 2015 and tapering starting only from December, emerging markets have effectively received a three month breather. So will the buyers return?

A lot of folks have been banging the drum about how cheap emerging markets are these days. But imminent Fed tapering has been scaring away any who might have been tempted. Plus there is the economic growth slowdown that could knock profit margins at emerging market companies. Bank of America/Merrill Lynch which runs a closely watched monthly survey of fund managers shows just in the following graphic how unloved the sector is relative to history:

So should people be buying? BofA/ML certainly thinks so: its strategist Ajay Kapur suggests emerging stocks are 20 percent undervalued. He acknowledges all the risks out there but reckons they are all in the price by now: