Rather than moving in a synchronised manner, speakers at the Profit & Loss Forex Network Chicago conference predicted that emerging market (EM) performance has become divergent due to idiosyncratic factors within each country.
“In general, EM does well when you have at least two out of three things: one is global growth, two is a weak dollar, and three is lower US rates. So, if you look at this combination and where we are in the cycle, especially given all the easy money that we’ve had since 2008, I would be very careful with the emerging markets right now,” said Mo Grimeh, CIO at Mogador Capital Management at Profit & Loss Forex Network Chicago.
He highlighted countries that have a strong reliance on foreign capital – such as Turkey, Argentina, Brazil, South Africa, Indonesia and the Philippines – as some of the weaker links in the EM block. However, Grimeh also pointed out that these weaker links are unlikely to cause the contagion that has been witnessed in the past.
“I think that in the end, there are going to be winners and losers, but I don’t think we’ll see a scenario like ‘98 or ‘94 where everything sells off. Don’t forget, Venezuela has been in default for a year. If this had happened 20 years ago, most EM countries would be down 20 or 30 points, and guess what? Venezuela has completely diverged from the emerging markets space despite the fact that it is a very big part of the index – at one point it was close to 6%,” said Grimeh.
Similarly, Peter Azzinaro, global macro strategist, portfolio management, at Manulife Asset Management, highlighted EM countries that he is constructive on, namely Brazil, Chile, India and Indonesia, but also ones that his firm is currently avoiding.
“Manulife is not involved in Argentina and we are not involved in South Africa, Russia or Turkey. This is because, if we can’t explain the volatility when it starts to increase – and you know there are moments when it’s really difficult to explain why Argentina is at 60% interest rates other than the obvious – we aim to avoid these markets. And for us, that’s a discipline and a process that we go through as a strategy. For right now, we are constructively, cautiously optimistic about the four different countries that I mentioned, and we are actively involved in on the bond side. So there are some interesting stories to tell, but not as a basket. We don’t see it that way,” he said.
James Mackenzie Smith, a director at Record Currency Management in London, meanwhile, sounded a cautiously optimistic note regarding EM trading, arguing that the fundamental economics of these markets provide opportunities for carry trades to generate returns.
“I would say that the emerging markets are in a better position than they were, let’s say, in the late ‘90s. They’ve got more FX reserves and therefore are not so dependent on hard currency debts, the central bank heads are better equipped, and EM offer the best carry trade opportunity set in all of FX,” he said.
On this point, Mackenzie Smith was immediately challenged by Bob Savage, CEO of CCTrack, who was moderating the discussion.
“Stop right there. How has the carry trade been working out for you? It’s down 10% year-on-year annualised at a minimum. So EMFX is not trading on carry, so why do you think it’s going to start trading on carry now?” he questioned.
“Well we think that it’s part of a longerterm phenomenon,” responded Mackenzie Smith. “The standard macro definition of the carry trade is that when countries have current account deficits and need capital, they will offer higher interest rates which should exceed what the exchange rate is expected to depreciate by. Moreover, growth differentials in emerging versus developed markets drive relative real exchange rate appreciation, in addition to the carry trade in EM.”
Noting that the panellists had expressed a nuanced view on emerging markets and that they appeared to be constructive on some of these markets in the longer term, Savage questioned whether the main challenge when investing in these markets is one of timing.
“Is it just a timing issue? So the alpha is there, just waiting to be executed, but what about the 800 pound gorilla in the room which is trade? This panel is titled, “Geopolitics and the Investor’s Dilemma”, if I had told you that the US was going to slap $200 billion at 10% tariffs on China at the beginning of the year, where would you have thought the renminbi was going to be?” he asked.
In response to this, Grimeh pointed out an interesting shift that has occurred in the dynamic of how geopolitical risk works.
“Let’s take a step back for a moment,” he said. “Twenty years ago, when someone mentioned geopolitical risk to me I would think about Saddam Hussein invading Kuwait, oil supply disruptions or an election going bad somewhere in a big emerging country. What I’m trying to say is that 20 years ago, emerging markets were exporters of geopolitical risk. Today, it’s the G7 markets that are the net exporters of geopolitical risk. You’ve had Brexit, the policy changes in the US, and in the last two years the entire focus has been on European elections: French elections, Dutch elections, the Italian election, the Spanish elections. No one cared about the Indian election, which went fine, no one cared about some of the elections in the larger emerging markets. So I think the problem now is that developed countries are becoming net exporters of geopolitical risk. And for me, that’s a really big concern.”
Given these comments from Grimeh, it was interesting that when the speakers were asked to identify key risks that they thought financial markets were not recognising or pricing in properly, they highlighted risks in more developed markets.
For example, Azzinaro expressed concern that US equity is “way overvalued”.
“Certain sectors and certain companies have multiples that are really tough for us to explain,” he said. “People are not really paying attention to the equity market, it just continues every day to go up and up and up. And so we think that, that’s an area for the rest of the year that could cause a lot of pain, especially for those that are managing a 401K because everyone tends to want to get out at the same time. We don’t see a capitulation happening, but we see that as sort of a red zone that is starting to get a bit frothy.”
Following on from this point, Mackenzie Smith highlighted that the continued unwind of quantitative easing could have an important impact on markets.
“I would never underestimate the ability and willingness of central banks to prop up asset prices. I know that’s not their explicit objective and some people will say that interest rates are already zero bound – or close to – and we could run out of assets, but the reality is that we are unlikely to run out of (say) gilts to buy and there are always other tools that central banks can use.”
Indeed, Grimeh pointed out that the prolonged period of low, or in some cases negative, interest rates coupled with the amount of money printed by central banks over the past 10 years is unprecedented, and that the unwinding of this process is equally so.
“For me, this is not a geopolitical risk, but it’s a major unwind risk that is out there,” he said.
Tying together the themes of quantitative easing, geopolitical risk and emerging markets, Savage later commented: “I think China’s role in the recovery of emerging markets in 2009 is understated. The quantitative easing by the US and Europe got all the headlines, but China implemented a particularly powerful stimulus package and imported a tremendous amount of commodities and supported emerging markets, particularly in Latin America.”
Meanwhile, Savage argued that the developed Western countries have endured an unexplained depreciation in the growth of productivity over the past 10 years and have challenging demographic, political and growth expectation problems that need tackling.
“This is not a great place for an economic turn to occur when all of those things are stacked up,” he said.
Having said that, Savage also pointed out that in the US, deregulation is helping to drive short-term confidence in the small and medium business environment to historic highs, consumer confidence is at an all-time high, in part because of the strong job market, and GDP growth has finally broken out of the 1-2% range.
“If this continues and we have 3% growth next year, then to my mind this will be the reason why the dollar will go up, because that’s when interest rate expectations are at a turning point. People expect the Fed in the next three years to cut rates, that the ECB will continue to raise rates and that the BoJ will move away from buying every government bond and that these things will converge again. And to me, the dilemma that we all have is this expectation that the US is going to be going down and everybody else is going to be going up, that’s what I fear.”