Weak currencies, a rising dollar and a splurge on cheap debt are some of the headwinds facing emerging markets.
Are investors in emerging markets in for a nasty shock? The omens do not look good. Emerging market currencies are in the throes of the worst sell-off since 2015; the rising oil price and a resurgent dollar are strong headwinds against growth; Argentina’s right-wing reformist government is seeking a credit line from the International Monetary Fund (barely a year after selling global investors a 100-year bond that was more than three times oversubscribed); and the continuing threat of a US/China trade war hangs over the Asia Pacific region.
These may prove to be temporary blips. However, increasing signs that global synchronised growth is beginning to stall, coupled with a splurge on cheap credit, will be more difficult hurdles for emerging market countries and investors to overcome.
But all is not gloom and doom. A large slug of the recent gains from developing Asian markets have come from companies engaged in the digital and wider technological revolution. Investors may pause for thought and cash in on some of the giants that have led the way (few Asian or global emerging markets funds do not have info tech and digital leaders Tencent, Alibaba, Samsung, Taiwan Semiconductor or Baidu among their top 10 holdings, for example), but fund managers in this space clearly believe there is plenty more to go for in the medium to long term.
Then there is the much-touted demographic advantage that emerging markets generally have over developed counterparts: young, increasingly well-educated populations, and aspiring and growing middle classes. An additional attraction for investors is the fact that companies in these markets are not as highly valued or as well-researched by analysts as those in the West.
In the midst of a crisis (or threat of one), these advantages tend to be forgotten in the rush for the exit. But patient, long-term investors should continue to bear them in mind. Unfortunately, it seems they will require strong stomachs in the near term, and need to develop a nose for sniffing out selective bargains that should show their true worth in years to come.
But first let’s put some flesh on the bones. From the end of March to early May, JPMorgan’s emerging market currency index following 10 leading emerging market currencies fell by more than 5 per cent against the dollar in less than six weeks, led by some nasty falls for the Russian rouble (9.7 per cent), Argentinian peso (8.2 per cent) and Turkish lira (7.8 per cent).
Investors should not expect any immediate respite from plunging emerging market currencies. From a short-term technical perspective, these currencies will continue to suffer as ‘carry trades’ are unwound. The classic carry trade is to borrow in low-interest denominated debt, such as Japanese yen, and invest in high-yield currencies such as Brazilian real or Argentinian peso.
For the typical investment bank trader, when the carry trade currency you’ve invested in plummets, it does nothing to boost the bottom line – or the annual bonus. That suggests that many of these trading positions will be unwound, heaping further pressure on emerging market currencies.
That inevitably feeds into local stock market valuations too. Companies that are particularly at risk are those that have taken on a lot of leverage, particularly hard currency debt (typically the dollar). With the US expected to raise interest rates at least two or three more times this year to around 2.25 per cent, dollar-denominated loans on a floating rate of interest become increasingly difficult to service, and more so when the ‘home’ currency is losing its value against the dollar.
Risk to trade
Then there is the prospect of a trade war. Washington’s demand that China drastically cuts its annual trade surplus with the US – which has reached $337 billion (£250 billion) – by two-thirds within two years is not going down well in Beijing. Neither is the demand that China scales back on ‘Made in China 2025’, a policy that seeks to promote Chinese companies to global leader status in high value sectors such as information technology.
Should the trade negotiations go as badly as many observers expect, retaliatory responses will heap further pressure on corporates and countries reliant on a weak dollar. In times of geopolitical stress (of which there is an abundance), investors tend to flock to the dollar, so rising US interest rates coupled with a rising dollar spells bad news for highly indebted emerging nations and corporates.
Indeed, the Washington-based Institute for International Finance (IIF) reckons that global debt increased by nearly 10 per cent, as much as $21 trillion, in 2017 – taking the total to $237 trillion. Economist Michael Roberts points out that much of this extra debt has been incurred by China, but ‘most of it is in local currency, not dollars, and China has huge foreign currency reserves in dollars that provide a buffer for any debt collapses’.
However, Roberts adds that higher US interest rates raise the prospect of a debt crisis in other emerging economies less well placed than China. ‘Dollar and euro debt now tops $8 trillion in these countries, or 15 per cent on average of all debt. According to the IIF, “stressed” firms now account for more than 20 per cent of corporate assets in Brazil, India and Turkey, and those companies where profits are greater than interest costs are shrinking fast.’
Wealth care providers
This is all painting a pretty gloomy picture for investors, in the short term at least. There are, however, a number of specialist Asian and emerging market funds run by managers with an eye on quality and wealth preservation that look interesting today. While they will not be immune to a general capital flight from these regions, they can be expected to hold up well, and make the most of a bounce.
Three investment trusts in particular take the eye, two focused on Asia and the other a global emerging markets trust. Schroder Asian Total Return Investment Company, a Money Observer Rated Fund, is a good choice for more cautious investors. This may seem at odds with its current high weighting to information technology and a focus on small to medium-sized companies, but the managers employ hedging techniques to mitigate risk and help protect wealth in more volatile times.
Its performance over three and five years ranks among the best, which is reflected in its current rating. With the shares priced at 357p, they are quoted on a 2 per cent premium to net assets, and gearing of 4.5 per cent raises total assets to £321 million. The managers recently said: ‘With most regions now surprising with stronger-than-expected inflation numbers, the risk of central banks overtightening and hiking interest rates excessively is therefore also higher. We are looking at ways of reducing risk in the portfolio.’
Unlike the Schroders-managed trust, Aberdeen Asian Smaller Companies Investment Trust is emerging from a lengthy period in the doldrums. It focuses on Asian and Australasian companies with market capitalisations of less than $1 billion at the time of investment. The trust’s active share ratio of 98.9 per cent shows how far it is positioned away from mainstream benchmark index weightings. Net gearing of 8.7 per cent raises gross assets to £465 million. At a price of £10.55, the shares are quoted on a discount of around 13 per cent to the trust’s net asset value. In the words of the management team: ‘Our long-time focus on quality and value should serve us well, with our holdings having the wherewithal to withstand these volatile times.’
Fundsmith Emerging Equities Trust (the author was an investor in this trust at the time of writing), managed by Terry Smith with the same clear philosophy that has driven the success of the developed market-oriented Fundsmith Equity fund, has recently performed comparatively well, following nearly three years of dull returns since its launch in June 2014.
Loyal private investors have contributed to the share price, currently £12.55, remaining persistently above the trust’s net asset value. But the current premium of 2.9 per cent compares well against a near 11 per cent premium following the trust’s launch, and the trust has been issuing new shares to meet demand. Total assets for the trust, which does not employ gearing, stand at £314 million.
The trust’s portfolio features firms that even avid emerging markets watchers are unlikely to have heard of. In the annual report to the end of 2017, Smith states: ‘None of the top 10 constituents of the MSCI Emerging and Frontier Markets index are, in our opinion, of sufficient quality for inclusion in our portfolio.’
He adds: ‘[In 2017] 40 per cent of the MSCI Emerging and Frontier Markets Index total return came from just four stocks: Tencent (and stakeholder Naspers), Alibaba, Samsung and Taiwan Semiconductor, none of which we own or wish to own.’
The annual report, which is choc-full of insights into what has been driving emerging market returns, and a good read, is available to download from the company website (www. feetplc.co.uk).
Investing in emerging markets goes hand in hand with periods of high volatility, but that also brings opportunity for actively managed funds and their investors.