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Emerging markets: five important global macro indicators to watch

A monthly insight from James Syme and Paul Wimborne (pictured), managers of Pendal’s Global Emerging Markets Opportunities Fund 

  • Five important global macro indicators to monitor when assessing risk and opportunity in the higher-risk, more capital-flow sensitive emerging markets.
  • Conditions that have led to capital inflows, stronger currencies and good returns to equity investors are still in place.
  • Find out about Pendal Global Emerging Markets Opportunities Fund

IF YOU wanted to paint a negative view of the emerging market asset classes (equities, bonds and currencies), there would be several pieces of evidence in macro conditions to point to.

Traditionally, the northern hemisphere summer is seasonally difficult for risk assets.

Covid-19 case numbers are again moving in the wrong direction in some countries.

And the surprisingly hawkish June commentary from the Federal Reserve has seen a rapid shift in a number of financial market indicators that are not supportive of risk assets.

St. Louis Fed president Jim Bullard made these comments in June:

“FOMC was surprised on the upside over the last few months… recent data is very good news… by the time you get to the end of 2022, you’d already have two years of two-and-a-half to 3% inflation. To me, that would meet our new framework where we said we’re going to allow inflation to run above target for some time, and from there we could bring inflation down to 2% over the subsequent horizon.“

This saw a sharp upward move in shorter-term US bond yields as the markets priced in tapering and a US rate hike in 2023.

A June Financial Times opinion piece by former India Reserve Bank governor Duvvuri Subbarao was an important indicator of the current environment for emerging markets (particularly the higher risk ones).

In the article, Emerging markets are right to worry about capital flows, Subbarao discusses the impact of foreign capital flows on India and the central bank’s resulting policy dilemma:

“With extraordinarily loose money supply and low returns in the rich world, emerging markets inevitably become a destination of choice for investors looking for high yields…

“The RBI has been in the market almost continuously, buying dollars to prevent an unwarranted appreciation of the rupee. But buying dollars results in extra rupee liquidity which could go beyond the central bank’s comfort level.

“The RBI could of course mop up the extra liquidity by selling bonds. But such a move would cause interest rates to spike, resulting in the economy being swamped with “carry trade” dollars looking to make money on the yield differentials.”

Subbarao’s main concern is that, when inflows become outflows, India (and other, similar, emerging markets) will see a liquidity crunch and a hardlanding in the economy and financial markets.

We agree with his diagnosis of the mechanism, but not (yet) his concern.

Generally, the conditions in emerging markets that typically mark the top of the capital-flow cycle have not yet occurred: sustained increases in credit and money supply, high capacity utilisation, buoyant financial markets and in particular, weak current account balances.

Five indicators to monitor risk and opportunity

We think there are perhaps five important global macro indicators to monitor when assessing risk and opportunity in the higher-risk, more capital-flow sensitive emerging markets:

1. Capital flows into the bond markets of emerging economies

One event in the mind of many investors is the ‘Taper Tantrum’ in the second quarter of 2013.

When the Fed announced that it would, at some point in the future, reduce the volume of purchases of assets, it triggered a sharp rise in US yields and significant weakness in the currency and bond markets of many emerging countries as capital flowed out and back into US dollar assets.

The fear is that the Fed’s indication of future policy tightening will have a similar outcome.

We are much less concerned.

In particular, positioning in EM fixed income markets is more benign, in our opinion. The years leading up to the Taper Tantrum had seen significant capital flows into the riskier emerging markets, and had driven down bond yields relative to US yields. (This gap is the heart of the carry trade that attracts and keeps those flows into Emerging Markets).

We estimate that for the six main riskier emerging markets (Brazil, Mexico, South Africa, Turkey, India, Indonesia), net foreign capital flows into government bonds in the year before the Taper Tantrum were over US$100 billion.

Right now that number is less than a third of that.

Similarly, the average ten-year local currency bond spread over US ten-year bonds was, we estimate, 1.5% below its long-term average. Now it is 1% above the long-term average.

We would concede that US-denominated bonds look expensive relative to history, but these are now a small part of the funding mix for mainstream emerging market

2. Currencies in the riskier markets look reasonably valued

We have written at length this year about large moves in terms of trade and current account balances in some of these markets (particularly Brazil, Mexico, India and South Africa) and how we see those underpinning currency valuations.

We think a lot of weak hands were flushed out of riskier emerging markets in the middle of 2020. We do not see the same positioning in equity or bond markets that we had back then (or, indeed in 2007-08, the previous period of excessive optimism towards the asset class).

3. Commodity prices are a significant driver of inflationary concerns in the US

It remains our view that Chinese credit growth is contractionary at the margin — and the Chinese economy is slowing.

Chinese demand remains a major driver of global commodity prices. We have seen heat go out of some of the most dramatic commodity markets. For example the Chicago lumber future contract finished June below US$800 per lot after peaking in May at US$1686.

4. The Fed’s own long-term forecast for the peak US policy rate remains at only 2.5% (and, notably, is unchanged since before the pandemic).

If the peak of the hiking cycle is only 225bp above current levels, it is likely to have far less impact than, say, the 375bp that was expected in 2013.

5. Forecasts for both GDP growth and equity market earnings are still being revised up in our preferred emerging markets.

This is not a universal phenomenon. But these improving expectations are a powerful support for markets — not only equities, but also currencies and bonds — as better conditions attract capital inflows.

Countries to avoid

Following on from that last point, we believe investors should always be selective when investing in emerging markets.

There are two types of countries we think lack the economic fundamentals to be attractive at this time.

The first are the South-East Asian economies. In this region growth recoveries have been weak and the next move in policy rates is likely down, not up.

Malaysia’s commodity sectors have been more supportive of growth there (although we remain zero weight). But we see a lack of a compelling growth stories particularly in Indonesia, Thailand and the Philippines.

The second country we choose to avoid on economic grounds is Turkey.

Turkey has had a very significant credit boom in the last few years due to unorthodox fiscal and monetary policy.

With the current account deficit elevated, inflationary pressures mounting and a weakening currency, the pressure on the central bank to hike rates is a defensive one to prevent capital flight, rather than a reflection of strong growth.

Bob Farrell, the legendary head of research at Merrill Lynch, is famous for his “10 Market Rules to Remember”. His fourth rule says in part that “rapidly rising or falling markets usually go further than you think”.

In our time in emerging markets we’ve found this is very much the case for the emerging market capital flow cycle.

In good times currencies appreciate far more — and interest rates and bond yields fall much further — than predictions.

Between 2003 and 2008 Brazilian policy interest rates fell from 14.25% to 11.25%. At the same time the Real strengthened from BRL 3.60 to the dollar to BRL 1.60.

We believe the conditions that have led to capital inflows, stronger currencies and good returns to equity investors are still in place.

We do not agree that a repeat of 2013 is likely to happen soon.

We think there is plenty of scope for a positive capital flow/growth cycle to continue in emerging markets.

Markets usually go further than you think.

About Pendal Global Emerging Markets Opportunities Fund

James Syme and Paul Wimborne are senior portfolio managers and co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here.
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here. 


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