By Peter Eerdmans, Co-Head, Emerging Market Fixed Income
There have been what we consider some misguided comparisons with the 2013 ‘Taper Tantrum’. Co-Head of Emerging Market Fixed Income, Peter Eerdmans, explains why we think this is quite a different sell-off, more akin to a typical mid-cycle market correction.
What’s driving the move?
US rates backdrop
Like during the 2013 taper tantrum, part of the driver of the sell-off has been a US policy shift that has altered the relative attractiveness of EMD assets. In 2013 it was the tapering of quantitative easing. In 2018, the weakness has been in sympathy with a sharper pace of rate normalisation and quantitative tightening in the US.
This isn’t a new phenomenon. During previous episodes (2004, 2005, 2006) sharp re-pricings in US rates drove a market correction in the asset class. However, over the full US hiking cycle of 2004-2006, the Fed hiked a total of 4.25%, while both local and hard currency EMD returned over 10% annualised during this period.
The pace of US rate tightening has lessened in recent weeks and the outlook from here should be much more modest. Unlike 2013, when the Fed was only just beginning to step back from QE, we are potentially more than midway through the current Fed hiking cycle, therefore we feel the current backdrop is much more analogous to the 2004-2006 episodes.
Scope of sell-off
Like 2013, those emerging markets with the greatest vulnerabilities have been worst hit. However, unlike 2013 the list of countries with genuine vulnerabilities is more modest. Aside from Argentina and Turkey, which both have significant external vulnerabilities, most other emerging markets are in better shape. For instance, the huge adjustment in recent years has generally seen EM current account balances move from deficit to surplus.
In 2013, outflows and market weakness caused significant tightening to financial conditions directly through currency weakness and also through concurrent policy rate tightening by EM central banks, which reinforced the sell-off momentum. However, this time around, the impact has been quite marginal outside of Argentina and Turkey.
Thus, we don’t think the tightening in financial conditions can derail what is a relatively healthy EM growth story. This is another key differentiator from 2013 when EM was slowing after a long boom which had resulted in overheated economies, excessive credit build-up in some markets and stretched current account deficits. Things are quite different now. EM economies are generally early cycle, with growth recovering after the sustained slowdown in 2013-16. As a result, there is considerable slack across most of our markets. This affords room for growth to accelerate without stoking inflation or damaging their current account deficits. Moreover, the global growth backdrop remains relatively strong and commodities are broadly well supported.
Valuations should never be taken in isolation, but with the relatively positive fundamental backdrop we think the sell-off has introduced some genuine value in the asset class, particularly in local currency bonds where we already felt valuations were quite compelling. On the cusp of the taper tantrum EM currency valuations were still close to their 2011 highs, whereas there is now a buffer of between 15-17% in real effective exchange rates. Similarly, the real yield buffer is materially higher in EM now. Credit spreads are arguably less compelling on a purely backward-looking basis. However, unlike 2013 credit fundamentals are on a positive trajectory so we think the recent back-up has introduced some value into spreads.
Risks to watch
There are, of course, risks to this thesis. Trade war rhetoric is a key risk that we think is one of the reasons why this sell-off has become more extended than previous bull market corrections. At the time of writing, we think the material effects of the trade war will be marginal. However, we expect headline risk to continue over the summer, as Trump tries to cajole trading partners. Another factor that we are watching is the composition of global growth. The US fiscal impulse has helped to drive the US economy to outperform the rest of the world in the second quarter.
EM economies typically do best when the global economy is growing strongly, but EM is outpacing the US. Our base case is that the pace of US growth moderates through the second half of the year from what we believe are unsustainably high levels. Linked to this, another sharp sell-off in Treasuries could derail the asset class. However, this seems unlikely, with US inflation still looking well anchored and rate hikes for the rest of year now largely priced in the front end.
We remain constructive
Overall, we feel the asset class is in much better shape than 2013. Fundamentals and valuations are both supportive, and the sell-off has not produced the second-round effects that could trigger a further leg down in the asset class. We don’t see the features required for an extended bear market, although we are closely monitoring risks that could change the picture. Going into the third quarter, we are constructive on the asset class and have a modest overweight beta across our portfolios.
This material is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual results may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, issued July 2018.