December-January 2017


2016 was the year emerging markets returned to the spotlight, as they regained ground since the 2012 sell-off. Funds Europe asked our panel if this appetite will persist in 2017. Anthony Simond (investment manager, Aberdeen Asset Management)
Jan Dehn (head of research, Ashmore)
Damian Bird (lead portfolio manager, LGM Investments, a part of BMO Financial Group)
Mark Te Riele (head of marketing, Asia-Pacific and emerging markets, BNP Paribas Investment Partners)
Stephen Tong (director and senior equity product specialist, HSBC Global Asset Management) Funds Europe: Emerging markets have shown signs of recovery. Is it sustainable?
Jan Dehn, Ashmore: There needs to be a distinction made between the fundamental story behind emerging markets, and asset prices. Asset prices have been primarily driven by QE [quantitative easing] programmes by the four major central banks that have bought $15 trillion of bonds. That’s just under 20% of all outstanding bonds in the entire Western world – yet they have not bought a single emerging market bond. Institutional investors have responded to QE by buying the same assets that central banks have bought and it has led to a giant portfolio shift out of emerging markets and other markets where there is no QE, and into the QE markets. A tremendous move in asset prices has resulted from this. Money has been sucked out of the asset class – emerging market currencies are down 40%, bond yields are up around 300bps in real terms, spreads are twice as wide as they were in 2006 and there’s probably not a single emerging market asset management firm that has seen an increase in their assets under management in the past five years. But what’s interesting about the situation in emerging markets right now is the real effect of exchange rates, which are back to the levels we last saw in 2003. This means competitiveness is back to those levels and asset prices are extremely cheap due to the asset allocation effect resulting from QE. Emerging markets have been subjected to a significant amount of headwinds over the last few years – the ‘taper tantrum’ and commodity prices, for example – yet despite these and other shocks, there have been remarkably few sovereign defaults. I think the emerging market resurgence has legs – the primary obstacle is that a lot of investors are now heavily overweight in developed market assets and are scared about where they will find their next source of returns, and when they are scared they don’t buy emerging markets. Mark te Riele, BNP Paribas IP: Towards the end of the last emerging market rally, which ended in 2011/12, investors underestimated the risks in emerging markets; there was the ‘Brics’ hype, with people, including retail investors, allocating heavily to China and other emerging markets. Investors are now overestimating the risks and underweighting these markets. However, emerging markets, particularly in Asia, are in much better shape than at the end of the last rally. There is less reliance on external debt, domestic economies are healthier, and economic development is more self-sustained.  So what we have now, despite emerging market equities outperforming developed markets by 12% this year, is investors sitting on the sidelines. Stephen Tong, HSBC Global AM: It’s no surprise that emerging market valuations are low. Profits drive markets and profits since the last emerging markets rally following the financial crisis have been flat or declining. Much of that is connected with the decline in commodity profits – the oil-gas-materials complex has fallen dramatically and profit growth in other sectors hasn’t made up for that, except in technology with the advent of new business models, such as Alibaba. But commodities now seem to have stabilised, meaning we shouldn’t see profit headwinds, and with some economies re-accelerating in terms of industrial production and exports, it’s setting the stage for profit acceleration. This would normally lead to multiple expansion, which could underpin the rally and allow it to continue. Anthony Simond, Aberdeen: The yield on two-thirds of the JP Morgan global bond index is less than 1%; more than a quarter of the index is negative yield; and the pure EMU index is worse. In contrast, emerging market debt displays both spread and yield. Many investors are very scared. A lot of institutional investors got burnt in the last four or five years due to the plummet in emerging market foreign exchange. It could be that flows – which will take time to come back – will be aimed more at emerging market bonds in hard currencies where FX [foreign exchange] risk can be managed a little better than on the local-currency side. Damian Bird, LGM Investments: The key point for me is the separation between asset price behaviour and fundamentals. The reasons for anyone to invest in emerging markets ten years ago are exactly the same reasons as they are today and will be ten years from now: it’s down to the fundamentals of long-term growth and other powerful factors that will not be derailed by short-term cyclical elements. Eighty per cent of the world’s population live in emerging markets. Many are poor but every month they are getting a little more money in their pocket. There’s a huge demographic story. In India alone, there will be 200 million more people in the next 15 years. Urbanisation is a powerful theme and still has a long way to go. There are basic economic catch-up drivers, such as high returns on incremental infrastructure investment and technological spill-over benefits. I would argue that things are different this time because if we look at the positive arguments for emerging markets and contrast them with the rest of the world, I think the spread between those two worlds is actually the greatest it’s been in recent times. Funds Europe: Which countries, and which asset classes, are of most interest in terms of returns? Simond: At the moment in hard currency bonds, we like Argentina a lot. We think that Argentina is coming in from the cold. It has very low levels of external debt and they have one of the best economic teams in Latin America and, probably, in all emerging markets. Latin America in general is slowly moving the same way. Argentina, Peru and arguably Brazil have some really good technocrats in place. In frontier markets, we like Ghana. Recovering from pretty high twin deficits, Ghana is now quite entrenched in the IMF programme and appears to be moving in the right direction. Georgia is also a good place to do business. And then sometimes you have to look at the more scary countries like Iraq. Iraq also has an IMF programme and is doing great stuff in terms of oil production. They also seem to be winning the war against Isis, so now maybe is the time to get involved there. Dehn: It is important to look at the individual opportunities in each country rather than in blocs. However, there is a bit of a bloc story that seems pretty much consensus by now, which is that Latin America was beaten up much more than other emerging market regions during the last four years. There are various reasons, such as commodity prices. Latin America also has the lowest savings rates in emerging markets, meaning they issue bonds to tap into foreign savings. But this means that when there are external shocks – like the dollar rally, the taper tantrum and the start of the Fed hiking cycle – Latin America’s financing gets more disproportionately affected than in other regions. Yet, as Latin America has the bigger downturn, it also makes them very cheap – and coupled with very transformative policies, there are real opportunities there. We are looking at local currency bonds in Argentina and I expect Argentina’s debt market to become very large. Also, we like Venezuela; it has the highest-yielding bond on Earth – it’s been two years and they haven’t defaulted; that’s a 50% return in dollars over two years. Te Riele: In April we launched an emerging market multi-asset income product and at present we think Asian equities, primarily the defensive sectors, look very attractive, supported by strong economic fundamentals. But overall, we favour China and India. Although Asian fixed income is still interesting, yields have come down quite a bit already, so are a bit less attractive compared to earlier in the year. We are also interested in Latin America – though I would say the Argentinian hard currency trade will have to be done quickly as its interesting elements are fading. Also, Brazil is coming back in favour and looking more positive. Bird: Because regions correlated with powerful, long-term structural themes interest us, we favour emerging markets with domestically focused themes. It isn’t necessarily the best strategy to invest in emerging markets that predominantly export to the West, because in our opinion that’s not really investing in emerging markets. If you’re investing in many of the companies in Korea or Taiwan that sell most of their goods and services to  the US and Europe, that’s much more correlated to what’s happening in the West than the attractive fundamentals of emerging markets Indonesia is hugely interesting on a long-term perspective; India’s understandably the darling of emerging markets right now; the Philippines was once the darling. It could be argued things have changed a little, both from a political perspective in the last six months, in some of these regions also from the currency perspective, but we still think that focusing on the domestic drivers and the strong, structured themes is where you find quality pockets that are really interesting long-term. Tong: Analysis shows there is reasonable explanatory power for emerging market stock returns by looking at individual countries, whereas developed-market drivers are more around sectors. Yet within each country, there’s a dispersion and choice, resulting in winners and losers. If you buy a country portfolio you’re typically buying a portfolio of 20-40 stocks. If you buy a GEM [global emerging markets] portfolio, you’re investing in perhaps the best ideas within each of these countries. The question is, what do clients want from their emerging markets exposure? For example, they might want diversification away from Asia because in a core GEM portfolio, Asia accounts for 70% of index weight. On top of that, there is the question of how to allocate tactically – should they rely on fund managers to find the best ideas, or should they take a thematic view because different managers may take different exposures? Or do they take tactical country bets with either a country portfolio or an ETF? It’s one thing to say you like Latin American banks, but you may prefer to buy individual names versus buying a fund. It’s one thing to say you like Latin American banks, but how would you access them if buying funds as opposed to individual stocks? Te Riele: It is interesting to see that there are hardly any Bric funds left! Six years ago there were tonnes of them. They all died because people don’t dare take that type of risk any more and, instead, they will have diversified emerging market portfolios. There are a lot of flows into ETFs, which is something investors need to be careful about, because an ETF can be a great play for US equities and other developed equities, but there should be more caution towards emerging markets. Dehn: Passive works if emerging markets become the favourite beta trade and go up for a little while. A rising tide lifts all boats. But emerging markets have a problem from a passive investment perspective. If fundamentals deteriorate, then there will suddenly be a big differentiation between good and bad emerging market bonds. Not being able to overweight and underweight, or even leave, can be very costly. In 2001, anybody who was a passive investor in emerging market fixed income sat on a 20% position in Argentina; the recovery value on those bonds was 30 cents in the dollar, which meant that you permanently lost 14% of your money, simply because you were market-weight. Tong: If the main allocation is to global equities, then global equity houses would usually access ideas from their emerging markets team. This may be good enough for some investors, but then again, perhaps investors would want broader diversification with more stock selection and broader access to better ideas. Investors, for example, might opt for a developed market portfolio combined with a diversified emerging markets portfolio. Te Riele: A typical investor that allocates to global equities is clearly underweight in emerging markets. And let’s face it, they’ve been right over the past four years until 2016. But this year, our case for emerging markets starts to make sense again and our ask is to convince people  that fundamentals are supportive. It’s an uphill task and the message would be better coming from a global equity manager who would be deemed more objective. But we see this year global equity managers and global bond managers increasing their weightings towards emerging markets. Funds Europe: Do movements in Federal Reserve interest rates still cause significant fluctuations in appetite for emerging market assets and how significant is this in the outlook for market volatility? Simond: I would say no. At the time of last year’s Fed hike,  there were other things going on, such as oil prices and the Chinese economy, which were having an impact. Bird: I agree that in the past year, rates haven’t had a significant impact, but there’s no doubt that over the last four to five years, that interest rate expectations in the West have affected risk-on appetite – though rates are irrelevant to the long-term themes we have mentioned. The Federal Reserve has absolutely nothing to do with those. But there are certainly asset price implications and we’ve seen that over the last four or five years with the risk-on/risk-off trade. I don’t know how long that pattern will last but, as it stands today, I think we have to accept that emerging markets remain in that bucket of risk-on assets. Dehn: I would agree that the effects of rate movements are not very severe now compared to just a couple of years ago, when even QE tapering in 2013, which is the mildest form of financial tightening you can possibly imagine, caused huge outflows. A big reason is the composition of the asset class ownership has changed. A lot of bank positions have been significantly reduced, partly by regulatory pressure. There are now two groups of investors in emerging markets: local and foreign long-term institutional investors. They tend to buy dips rather than selling on headline news. This creates an asymmetry where markets sell off less on bad news and rally more on good news.  You can see this in the way that emerging markets have reacted to risk events – such as Brexit or the Turkish coup attempt. There have been no material sell-offs, and I think that’s because there are very few sellers now. It is mostly institutions and they are buying in the dips. Te Riele: There may be short-term effects – particularly on currencies – but not in the long term over the coming years. The good thing about a rate hike, were it to happen in December, would be that it supposedly serves as confirmation of improved economic conditions in the US – and though we feel that emerging markets are more self-sustained as compared to five years ago, a confirmation of improved economic conditions in developed markets should still be helpful for the emerging markets. Tong: Historically, many of these countries had large exposure to external US dollar debt, so a rate hike would have caused some anxiety – but with a lower proportion of dollar debt and more mid-to-long-term debt than short-term debt down, there’s less immediate default risk. Nevertheless, there’s still a perception of correlation between the dollar index versus the emerging markets index. If interest rates rise, we might get this same reaction if many investors have an environment in their mind that is no longer the reality. But if we have a stronger economy, a stronger dollar is great for emerging market exports. Funds Europe: Apart from rate risk, what are the main risks ahead for investors in emerging markets now? Te Riele: Most headwinds as perceived by the market are obvious, though we think they’re quite moderate and often over-emphasised: a hard landing in China is often brought up but we don’t expect it to happen. There’s still the issue with non-performing loans in India and China, which we continue to watch closely.  Some headwinds are caused by developed markets. Take Brexit, which was a very short-term headwind, but it did have an impact and emerging market investors were concerned about it. But probably the biggest would be a US recession. However, they are all still quite moderate in terms of potential or likelihood to happen. Tong: A main risk is policy risk – not in terms of policy mis-steps, but the ability to implement their plans. Brazil is in need of fiscal and political reforms that are key to longer-term growth in the country, similar to what Mexico has planned with their broad reform programme. Bird: Some of the short-term risks are to do with polls, such as the Italian constitutional referendum and Austrian elections [which took place after this roundtable was held], though again, these are probably not big risks. Dehn: My main worry for next year is US inflation returning. I don’t think the US economy, the dollar or financial markets in developed economies could stomach the tightening required to crush inflation. Remember that policy rates in the US are currently nearly 200bps below neutral! Further financial repression could see the US look to hold down yields at the long end of the yield curve. The key for emerging markets if this happens is going to be whether a steepening of the yield curve is going to be accompanied by rising inflation expectations. If yields go up in line with inflation expectations, then real yields remain low and emerging markets could come into favour. On the other hand, if yields rise and inflation expectations fall, then real yields rise and that could hurt emerging markets a lot, but probably developed markets even more. Bird: The biggest emerging market economy out there is China. Most people are more or less agreed that at some point, there’s going to be an issue with the Chinese financial system. There are so many unknowns in terms of China’s financial system, the insurance sector, and state-owned enterprises (SOEs). If there is a problem in China, it will have a material impact on the wider emerging market asset class and even if an investor only has a low exposure to China, it will affect them. Te Riele: There is hardly any other government in the world other than China’s that has so many economic policy tools and is capable of making a direct impact on the economy, and from what I’ve seen, it’s often quite effective. When investors look at the balance sheet of China, often they look at the debt side and wonder at the size of the impact of defaults on the rest of the world. But would it really be so bad? All the debt is in renminbi and held domestically. It’s not that we, as global investors, are exposed to those bonds; it’s actually quite hard to buy them. And also don’t forget China’s government won’t often let companies default, which tells you that they will be able to control things should things go wrong. Dehn: China will likely grow around 6% per annum between now and the middle of this century and assuming the US grows 2% per year over the same period, then by the time we get to 2050, per capita GDP in China will be the same as in the US. But this means, of course, that China’s economy will be four-and-a-half times bigger than the US economy because there are four-and-a-half times more people in China than in the US. Funds Europe: How has the product set evolved to give investors coverage of emerging markets since the last positive phase in the region’s investment cycle? Tong: It’s evolved tremendously. Investors have broadened their definition of emerging markets and expanded their investment universe to frontier markets. There has also been the advent of emerging market country ETFs, which has given asset allocators another option as opposed to buying individual country funds. And there has been fundamental weighting instead of market-cap indexation. Alternative-weighting schemes take advantage of the inherent volatility and inefficiencies in emerging markets. These are alternatives to either a passive capital index fund, or an active manager. Also, investors are paying more attention to ESG and carbon – which I think will be very significant themes going forward. We’ve also seen introduction of lower-volatility strategies, which is a bit counter-intuitive because in a risk-on environment, there’s a feeling you need to be in beta-one strategy. Emerging market equities are volatile, and lower-volatility indices and products have tended to offer attractive returns and a smoother performance pattern. Bird: What we are seeing and hearing from our clients is a greater focus on ESG factors and themes along the sustainable investment line. We have seen a marked pick-up in interest in our dedicated ESG screened Global Emerging Markets strategy. Dehn: There has been sharp growth in blended debt funds, that is in funds where asset managers can invest across corporate, local and hard currency bonds within a single portfolio. Another important development is that quietly over the last ten years, the number of countries in the external emerging market debt index has doubled. Te Riele: As a result of outflows over the past four or five years, I expect there are actually less emerging market funds, particularly those with acronyms, like Brics. Those funds have disappeared and people are back to traditional emerging markets and global emerging markets funds.  In general there is more conviction in these compared to the past and that’s what people want. There has been increased interest in the small-cap space, too. The debt side is more stable since 2012. It is mostly regional, though there is hardly any Latin America fixed income products out there yet. Simond: There are higher-yielding products and also lower-volatility products, such as pure frontier market bond funds; there’s three or four out there now. But there are also investment grade-only funds that are needed by a lot of the pension funds and insurers that have an investment grade credit rating limit. Total returns funds linked to a benchmark like US treasury indices, meaning managers can allocate within the developed and emerging market spectrum. That takes a little bit of pressure off the client and puts it on to the asset manager, who should have a better understanding of the risks. Funds Europe: Do you see particular signs of demand for emerging markets investing from clients in these markets themselves, and are there differences to demand from developed markets? Dehn: Latin American institutional investors feel more comfortable investing at home. It is the same for Middle East investors and, indeed, for Asian investors too. This is fundamentally irrational, because they can’t all be right. Performance proves it. Global emerging markets perform better over the full cycle than regional funds. Te Riele: I fully agree, the home bias is everywhere, including developed markets. This is often also because of regulation. The Indonesian fund market, for example, has always been closed and investors could actually not invest abroad, so they have huge exposure to Indonesian equities. Now this market is opening up. This year we introduced the first global equity fund in Indonesia, which is a sharia product. But investors there feel a bit scared as well, particularly about Europe; talking about Greece in Asia is like talking about China in Europe. Funds Europe: Which events in emerging markets investing have been the most instructive over the past four or five years and what have you learnt from them? Simond: What stands out is just how jumpy investors have been over the last five years and how important communication from developed and emerging world central banks is; and when it all goes wrong, how quick investors are to get to the exit. So, the taper tantrum and China foreign exchange policy last year. Even if, you know, our own fundamental views are unchanged, the technical elements and sentiment of the broader market can have an extreme effect on asset prices. Sometimes I guess we have to think a little bit more about global sentiment rather than just focusing on the fundamentals of a particular country or story. Te Riele: It’s been very much the realisation that the image of emerging markets is not as good as I would have expected when I moved from Asia to Europe three years ago. I’d worked in Asia for ten years, I was excited about the opportunities in Asia and I went back to Europe, the views I found were a big shock. It taught me that emerging markets had an image problem, though this year it’s finally getting better. Bird: The last few years have shown the mismatch between where fundamentals are, and where equity markets are. Right now it is a very interesting time in emerging markets, because the disparity between perception and reality is quite large and that makes emerging markets an interesting asset class to look at. Dehn: Unfortunately the media views emerging markets as the financial equivalent of sex and death; EM news sells broadsheet newspapers if it is presented in a sensationalist manner. A reason why I write a lot of research is because I want to try to counteract this tendency towards sensationalism. A second thing I’ve learnt is that my confidence in EMs’ fundamentals has been justified. EM countries are far more resilient than many give them credit for. They  have come through some severe headwinds in recent years with remarkably little fundamental fallout in terms of defaults, IMF programmes and balance of payments crises. And the final thing is that I had clearly underestimated the myopia and herd dynamics among investors. I mean, investors that make long-term investment decisions will readily ditch their long-term views in response to some short-term volatility, and all the work that’s gone into manager selection and defining asset class allocations goes out the window after very short periods of market headwinds. ©2016 funds europe

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