The substantial volatility in Emerging Markets (EM) has recently triggered debates about the suitability of exposure to EM for a diversified portfolio. Understandably, there is a lot for EM investors to be worried about, particularly potential contagion coming from China’s slowdown. More broadly, underperformance of EM equities versus developed markets has become so pronounced that it raises a critical question: is EM underperformance becoming chronic? While shorting broader EM indices has been profitable until recently, borrowing costs on some of the major ETFs are becoming increasingly expensive.1 The more crowded shorting EM becomes, the more short-sellers are exposed to possible snap-back rallies that can be driven by marginally positive news such as unexpected Chinese fiscal or monetary stimulus, or the U.S. Federal Reserve (Fed) delaying its tightening cycle.
1997 versus 2015
Though the recent market environment for EM evokes memories of the 1997 Asian financial crisis as both can be characterized as highly volatile markets, it is prudent to examine the similarities and differences between the two periods.
- First, in 1997, many EM countries had fixed or pegged exchange rates which allowed them to borrow heavily in dollars. Because of market pressures and trade deficits, EM central banks were forced to intervene aggressively to defend their currencies, eventually causing a disorderly market adjustment that included sharp and painful down moves. Today, most EM exchange rates are floating.
- Second, the EM banking sector was less capitalized in 1997.2 Additionally, bank balance sheet leverage is less stressed today than in the 1990s and is bolstered by heavier reliance on deposits and less reliance on loans from foreign investors. Notably, Asian bank equities did not underperform the broader markets during the recent sell-off in August.
- Third, foreign exchange reserves coverage of imports and debt service are generally better than in the period before the 1997 crisis. Even accounting for the substantial August decline (an estimated $93.9 billion to $3.56 trillion decrease), Chinese reserves are more than sufficient to manage a currency devaluation in a controlled manner.
- Finally, one of investors’ biggest fears currently is that EM countries may introduce capital controls similar to Malaysia’s during the 1997 crisis. For countries running sizable current account deficits, such as Turkey, South Africa, and nations across Latin America, such imposition would likely mean a swift and severe decrease in foreign capital flows that would almost certainly result in recession. This makes it unlikely that the governments would choose to pursue this path.
Impact on Fed Tightening on EM
Another major concern in the market is whether there is more downside in EM if the Fed starts a tightening cycle. While many argue that 2013’s taper tantrum was a clear preview as EM fell, this time may well differ since the Fed has signaled its intentions for a long time and will likely raise rates at a measured pace. Analogies to 1994’s rate hikes may also be misleading as the Fed’s move then was unexpected. This time, the Fed will likely be focused on U.S. data but will keep a close eye on developments outside the U.S. That being said, the Fed is likely to delay any rate increases until the U.S. achieves clearly higher inflation and other major markets stabilize.
Positioning in EM
Managing EM exposure has become increasingly complicated over time and requires a sophisticated and vigilant mindset to adjust to ever-changing market dynamics. It has become too simplistic to think about EM investing based on concept-driven groupings such as BRICs, Next 11, Fragile 5, MIST,3 and other acronyms seemingly so beloved by EM investors. Also, it has been too narrow to think about Russia and Brazil as commodity plays, Mexico as a levered play to U.S. economic growth, or Turkey, South Africa, and Indonesia as chronic current account deficit countries vulnerable to currency shocks. Many EM companies are driven by a multitude of company-specific drivers and are impacted significantly by the efficacy of each management team’s approach to navigating external sector conditions. Channel-checking how a specific EM company is adapting to evolving demand conditions or input costs will continue to be an important skillset to be able to generate alpha in EM equities.
Opportunities created by ongoing volatility can be capitalized upon with disciplined and careful risk management. It is crucial to maintain flexibility in the portfolio and have the ability to take advantage of attractive valuations after the clouds of uncertainty clear. This means structuring a nimble portfolio with low invested levels and contained exposures to broader markets and currencies to leave dry powder to take advantage of attractive valuations once the clouds of uncertainty clear. Sticking to price targets is also an important discipline, particularly in light of the risks of short squeezes due to heavy positioning against EM equities. However, generating fresh short ideas can keep the directionality of emerging market portfolios under control. On the long side, the recent sell-off created attractive entry points for equities of quality companies in secular growth industries—such as low-cost airlines and food exporters—which benefit either from prudent hedging policies using derivatives or even from favorable currency moves. On the short side, continued opportunities will likely emerge in select developed market-listed companies in cyclical sectors whose revenues are tied to demand from EM countries. In certain cases, valuations may remain elevated and there could be further pressure on earnings.
In summary, EM has lately been an uncomfortable place to be invested; however, plenty of opportunities remain for those who can maintain a long-term perspective and stomach short-term volatility. Notwithstanding short-term moves, EM exposure is not likely to disappear from institutional portfolios where decisions tend to be based on long-term concerns rather than short-term volatility.
1 Borrowing costs on major ETFs have reached 4% annualized. Morgan Stanley Research, “EEM – MS Trading Thoughts – A Local Bottom”, September 3, 2015.
2 The banking systems in Indonesia, Malaysia and Thailand all carried non-performing loan ratios (NPLs) of 7-10% in the mid-1990s versus 1-3% recently. J.P. Morgan Asia Pacific Equity Research, “Eye on Emerging ASEAN”, September 8, 2015.
3 Mexico, Indonesia, South Korea and Turkey
Alper Ince, CFA, CAIA is a Managing Director and Sector Specialist for Long/Short Equity and Event-Driven Equity.
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