Global Investing

Strong dollar, weak oil and emerging markets growth

Many emerging economies have been banking on weaker currencies to revitalise economic growth.  Oil’s 25 percent fall in dollar terms this year should also help. The problem however is the dollar’s strength which is leading to a general tightening of monetary conditions worldwide, more so in countries where central banks are intervening to prevent their currencies from falling too much.

Michael Howell, managing director of the CrossBorder Capital consultancy estimates the negative effect of the stronger dollar on global liquidity (in simple terms, the amount of capital available for investment and spending) outweighs the positives from falling oil prices by a ratio of 10 to 1. Not only does it raise funding costs for non-U.S. banks and companies, it also usually forces other central banks to keep monetary policy tight, especially in countries with high inflation or external debt levels. Howell says:

If you get a strong dollar and intervention by EM cbanks what it means is monetary tightening…The big decision is: do they allow currencies to devalue or do they defend them? But when they use reserves to protect their currencies, there is an implicit policy tightening.

The tightening happens because central bank dollar sales tend to suck out supply of the local currency from markets, tightening liquidity.   That effectively drives up the cost of money, as banks and companies scramble for cash to meet their daily commitments.  Central banks can of course offset interventions via so-called sterilisations – for instance when they buy dollars to curb their currencies’ strength, they can issue bonds to suck up the excess cash from the market. To ease the tight money supply problem they can in theory print more cash to supply banks.  But while many emerging central banks did sterilise interventions in the post-crisis years when their currencies were appreciating, they are less likely to do so when they are trying to stem depreciation, says UBS strategist Manik Narain.  So what is happening is that (according to Narain):

Markets are forcing central banks into supporting growth or the currency. You absolutely have to sacrifice growth as we have seen in places like Turkey where liquidity has impacted the growth profile

Measuring political risk in emerging markets

(Corrects to say EI Sturdza is UK investment firm, not Swiss)

Commerzbank analyst Simon Quijano-Evans recently analysed credit ratings for emerging market countries and concluded that there is a strong tendency to “under-rate” emerging economies – that is they are generally rated lower than developed market “equals” that have similar profiles of debt, investment or reform. The reason, according to Quijano-Evans, is that ratings assessments tend to be “blurred by political risk which is difficult to quantify and is usually higher in the developing world compared with richer peers.

However there are some efforts to measure political risks, and unfortunately for emerging economies, some of those metrics seem to indicate that such risk is on the rise. Risk consultancy Maplecroft which compiles a civil unrest index (CUI), says street protests, ethnic violence and labour unrest are factors that have increased chances of business disruption in emerging markets by 20 percent over the past three months. Such unrest as in Hong Kong recently, can be sudden, causing headaches for business and denting economic growth, Maplecroft says. Hong Kong where mass pro-democracy protests in the city-state’s central business district which shuttered big banks and triggered a 7 percent stock market plunge last month.

As a result, Hong Kong jumped to 70th place in the index from a relatively safe 132nd place in the CUI which analyses governance, political and civil rights and the frequency and severity of incidents to assess the current and future civil unrest picture.

The people buying emerging markets

We’ve written (most recently here) about all the buying interest that emerging markets have been getting from once-conservative investors such as pension funds and central banks. Last year’s taper tantrum, caused by Fed hints about ending bond buying, did not apparently deter these investors . In fact, as mom-and-pop holders of mutual funds rushed for the exits,  there is some evidence pension and sovereign  wealth  funds actually upped emerging allocations, say fund managers. And requests-for-proposals (RFPs) from these deep-pocketed investors are still flooding in,  says Peter Marber, head of emerging market investments at Loomis Sayles.

The reasoning is yield, of course, but also recognition that there is a whole new investable universe out there, Marber says:

There has been so much yield compression that to get the returns investors are accustomed to, they have to either go down in credit quality or look overseas. Investors have been globalizing their equity portfolios for 25 years but the bond portfolios still have a home bias. We are starting to see more and more institutional investors gain exposure to emerging markets, and a large number of recent RFPs highlight more sophisticated mandates than a decade ago.

Ecuador: a successful emerging market?

A colleague of mine, Marius Zaharia (@MZaharia) interviewed Moritz Kraemer, Standard and Poor’s head of sovereign ratings for Europe, Middle East and Africa. (you can read the interview here) Kraemer offered this piece of advice to the African governments who are busily tapping bond markets these days:

    What I want to tell all those governments in africa is that you are not a successful market participant when you’ve issued your first eurobond. You are a successful participant when you’ve paid it back for the first time.   

A sound piece of advice. But where does that leave Ecuador which has a frequent history of default spanning three centuries? One might argue in fact Ecuador’s market strategy has been highly successful — not only has it avoided repaying creditors, it also seems adept at persuading them to part with more cash at regular intervals.

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).

Braving emerging stocks again

It’s a brave investor who will venture into emerging markets these days, let alone start a new fund. Data from Thomson Reuters company Lipper shows declining appetite for new emerging market funds – while almost 200 emerging debt and equity funds were launched in Europe back in 2011, the tally so far  this year is just 10.

But Shaw Wagener, a portfolio manager at U.S. investor American Funds has gone against the trend, launching an emerging growth and income fund earlier this month.

It’s a great time to launch a fund if you have a long-term focus in mind. Emerging markets trailed DM in terms of performance for a while, peaking at end of 2010 so we are 3-plus years into a down market and period of significant underperformance.

No more “emerging markets” please

The crisis currently roiling the developing world has revived a debate in some circles about the very validity of the “emerging markets” concept. Used since the early 1980s as a convenient moniker grouping countries that were thought to be less developed — financially or infrastructure-wise or due to the size or liquidity of their financial markets — the widely varying performances of different countries during the turmoil has served to underscore the differences rather than similarities between them.  An analyst who traveled recently between several Latin American countries summed it up by writing that he had passed through three international airports during his trip but had not had a stamp in his passport that said “emerging market”.

Like this analyst, many reckon the day has come when fund managers, index providers and investors must stop and consider  if it makes sense to bucket wildly disparate countries together.  After all what does Venezuela, with its anti-market policies and 50 percent annual inflation, have in common with Chile, a free market economy with a high degree of transparency  and investor-friendliness?

Deutsche Bank analyst John-Paul Smith is one of many questioning current index-based investing models which he says essentially provide a free ride to the Russias and Venezuelas of this world, who may be undeserving of investor dollars.  Simply by virtue of inclusion in the emerging index, a country becomes a “default beneficiary” of passive investment flows — from funds that hug or track the benchmark — Smith says. In a note he calls for the abandonment of current index criteria such as market access, liquidity or per capita income in favour of a “substantive governance-based view of risk”
In other words:

Emerging stocks lose again in November

By Shadi Bushra

After years of basking in their reputation as high-return hot spots, 2013 could be the year emerging equity markets finally lost their magic touch. Last month continued the litany of losses — seventeen of the 20 emerging markets listed on S&P Dow Jones indices ended November in the red, the index provider says. Contrast that with developed markets’ fortunes last month– 18 of the markets listed by the index rose, while eight fell.

So last month’s scores: Emerging stocks – down 2 percent; Developed stocks – up 1.6 percent. And for 2013 as a whole, emerging stocks are down 3 percent while developed markets are up a whopping 22 percent, approaching their 2007 peaks, according to S&P Dow Jones.

While each of the emerging market countries has their own unique cauldron of political and economic issues affecting their stocks’ performance, there is common ground too – the expected tapering of U.S. monetary stimulus.  The hardest-hit emerging countries were those that have too much exposure to investors in developed countries, who may move their money from the developing world once the cheap money begins to dry up.  Worst off was Indonesia where equities fell nearly 13 percent in November, and on the year they are down more than 23 percent.

Red year for emerging bonds

What a dire year for emerging debt. According to JPMorgan, which runs the most widely run emerging bond indices, 2013 is likely to be the first year since 2008 that all three main emerging bond benchmarks end the year in the red.

So far this year, the bank’s EMBIG index of sovereign dollar bonds is down around 7 percent while local debt has fared even worse, with losses of around 8.5 percent, heading for only the third year of negative return since inception. JPMorgan’s CEMBI index of emerging market corporate bonds is down 2 percent for the year.

 

While incoming Fed boss Janet Yellen has assured markets that she doesn’t intend to turn off the liquidity taps any time soon, JPMorgan still expects U.S. Treasury yields to end the year at 2.85 percent (from 2.7 percent now). That would result in total returns for the EMBIG at minus 7 percent, the CEMBI  at minus 2 percent and GBI-EM at minus 7-9 percent, JPMorgan analysts calculate.

Barclays sees 20 pct rise in EM bond supply in 2014

Sales of dollar bonds by emerging governments may surge 20 percent over 2013 levels, analysts at Barclays calculate.  They predict $94 billion in bond issuance in 2014 compared to $77 billion that seems likely this year. In net terms –excluding amortisations and redemptions — that will come to $29 billion, almost double this year’s $16 billion.

According to them, the increase in issuance stems from bigger financing needs in big markets such as Russia and Indonesia along with more supply from the frontiers of Africa. Another reason is that local currency emerging bond markets, where governments have been meeting a lot of their funding needs, are also now struggling to absorb new supply.

The increase is unlikely to sit well with investors — appetite for emerging assets is poor at present, EM bond funds have witnessed six straight months of outflows and above all, the projected rise in sovereign supply will come on top of projected corporate bond issuance of over $300 billion, similar to this year’s levels. (See graphic)