After reading the headlines recently it would be easy to believe the entire emerging world is in a state of crisis. But where there is crisis, opportunity usually follows.
Mismanagement by the Turkish government has caused inflation to surge to almost 25% and driven the value of the lira into the ground.
At the same time, Argentinian president, Mauricio Macri has been pleading with the International Monetary Fund (IMF) for emergency help as the peso falls. The South African rand also looks to be teetering on the brink.
All the while, the fire of political and economic instability is being fanned by US dollar strength, as the Federal Reserve raises interest rates and president Donald Trump’s threats of trade wars escalate.
However, a cross-section of emerging market managers at the Wealth Manager Retreat deem the ‘crisis’ as part and parcel of emerging market investing, saying the situation more widely is not as bad as it might appear.
‘Year-to-date, 2018 is proving to be a very volatile market. We have had several big negative headlines and they continue to put down sentiment in our asset class, for example, US dollar strength, Fed rate hikes and recently the Chinese trade war talks heating up,’ said Ernest Yeung, manager of T Rowe Price Emerging Markets Value Equity fund.
‘Certain countries, such as Turkey and Argentina, have been in the eye of the storm and they are on the mainstream media every single day.’
However, Yeung stresses that the amount of airtime the latter two countries are receiving is not reflective of their impact on the wider emerging market landscape.
‘We are very cautious about these events and analyse them in detail and keep monitoring them, however, I would point out one interesting fact: we talk a lot about Argentina and Turkey, but they’re actually less than 1% of the MSCI EM index.’
BlackRock’s Gordon Fraser goes so far as to describe the countries as ‘frankly tangential’ in the scope of emerging markets as a whole.
‘Argentina isn’t actually in the emerging market index and Turkey is about 0.5% so it’s broadly irrelevant as far as equity investors are concerned, so that sustainability and default risk in my mind is quite small.’
In fact, he actually sees the troubled countries as marginal outliers due to their large external debt piles, a trait not shared by the majority of emerging markets.
‘The original sin of emerging markets is borrowing debt that is not denominated in your own currency and it is the main problem that takes down emerging markets. Very few other countries have those kinds of debts.’
A buying opportunity
With other emerging countries not suffering from this ‘sin’ of excessive external debt, but having still been dragged down during the recent correction, many fund managers have been buying the dip.
‘It has clearly been a big dampener of sentiment, but what I would like to say is that in 19 of the last 20 years you have had a 20% drawdown in emerging markets – so it’s actually quite a normal occurrence,’ Fraser said.
‘This is a mid-cycle environment, so it is actually in a pretty good stage of the economic cycle for this to happen and in general, this is a buying opportunity presented by markets.’
Fraser points to Russia as being an extremely cheap market, given it should benefit from the high oil price and the depreciation of the rouble. However, the spectre of sanctions imposed on the country by the US weigh heavily on investor sentiment and are hampering growth.
The latest round of sanctions, following the poisoning of an ex-Russian spy Sergei Skripal and his daughter in Salisbury, have deterred Lazard commodities fund manager Terence Brennan from investing in the country.
‘We would love to be buying Russian oil, but the one concern we have is the Skripal sanctions.’
Elsewhere, despite the concerns developing around its weakening currency, which is approaching its lowest point since the Asian financial crisis, Fraser is eyeing opportunities in Indonesia.
‘Indonesia has had a very significant correction as well, but we think the political cycle there is favourable,’ he said.
Indonesia has an election in April 2019, which Joko Widodo, the incumbent, is expected to win, and Fraser believes this will lead to a continuation of the reform process currently underway in the country.
Fraser is not the only one looking to politics for salvation. Yeung thinks that despite South African president Cyril Ramaphosa’s reluctance to deliver market-friendly policies, he has South Africa on the right track.
‘The country has been in a slowdown for a long time and there are a lot of internal problems they need to solve. So after president Ramaphosa tackles those internal political issues, I think he will look at the economy.’
The slowdown in the country, Yeung explains has left domestic stocks in bargain territory.
‘Domestic stocks in South Africa are very cheap, they tend to pay good dividends and they have a higher than average management quality, so I am actually quite constructive on that country,’ he said.
However, Brennan is less positive: ‘If the contagion we worried about spreads from places like Turkey and Argentina and even South Africa that is something we have on our radar screen that we need to watch.’
He worries about South Africa’s platinum rating coming under pressure because of the weak currency and a production ramp up.
Can financials turnaround?
Given the recent volatility, financials might not necessarily be the first thought for many, but Yeung sees them as a sleeping giant.
‘Financials are actually the second largest underweight for EM investors and valuations are very cheap. We can find a lot of banks that trade below 1x book,’ he said.
‘The reason is that in the last one to two years, loan growth in emerging markets has been very slow, but our view is the asset class has hit a trough in Q1 2016 and it’s just a matter of time before the economic cycle gradually improves and loan growth accelerates. So we continue to hold a large position in financials.’
Yeung is not alone in this, with Fraser noting that even Turkish financials could be poised for a turnaround.
‘Turkey has been one of the countries in the eye of the storm, but they have taken some orthodox steps now, and, interestingly, Turkish... companies are able to fund themselves in markets. The debt markets opening to Turkey is a big positive and a good signpost for emerging markets.’