Emerging market assets are set to outperform in coming months despite the recent exodus of crossover investors on fears of a credit crunch in developed markets, leading investors say.
The result will reverse the prevailing logic – a legacy of the 1990s - that emerging markets are inherently prone to volatility and economic disruption. These comments come as European Central Bank president Jean-Claude Trichet decided to inject almost EUR100 billion into the overnight money market, to prop up banking sector liquidity.
“The problems this time are somewhere else, not in emerging markets,” said William Calvert, emerging equity portfolio manager at Axa Framlington.
He noted that many developing economies are now net creditors or run large current account surpluses, while emerging market companies are generally less leveraged than their developed market peers. As a result, most emerging market assets should withstand widening spreads in the US, so long as the world’s largest economy does not fall into recession, he said.
Axa has scaled back exposure to small-caps in emerging markets, and focused on the stronger domestic growth stories.
Enzo Puntillo, emerging market debt manager at Bank Julius Baer, pointed out the split between short and medium term outlooks. “I think we will see a clearer separation between the good stories and the bad stories, and we might even see the high-beta credits recovering some of their huge losses if things stabilize,” he said.
But in the near term, he noted that “more negative headlines out of the US will continue to have an impact on emerging market debt, because of crossover investors hedging through credit derivatives, who think EM debt valuations still look pretty attractive to sell.”
Among the good stories, Puntillo highlighted Brazil - with its high growth, falling interest rates, and current account surplus - as well as Colombia, together with the Philippines and Indonesia, both of which stand to benefit from Asia’s economic growth. If investors return to emerging equity markets, local currencies should make fresh gains as the dollar weakens in response to the US credit deterioration, he added.
Nicholas Field, emerging equities strategist at Schroders, which manages over $6.5 billion in emerging equity, warned that divided opinion on US prospects will continue to shake emerging markets in the short term.
“It is going to be much choppier than before,” he said, while acknowledging a long- term uptrend for the asset class.
Field said that slow growth in the US would not impact significantly on emerging markets. “They have their own internal drivers, especially in China,” he said. But he warned that US export-oriented sectors, such as Taiwan’s tech industry, would suffer, as would broader corporate earnings growth, though without putting “a serious dent in things”. He added that stocks where valuations have been driven up by rumours of private equity bids should be avoided, as leveraged loans dry up.
To date, Schroders has avoided severe fundholder outflows, suggesting a more robust sentiment than in previous bouts of risk aversion. Field believes the Asian bid is as important for equity valuations as the Asian growth story.
“Over the past 12 months, we have seen massive inflows from Asian retail investors. My sense is that, as long as their own economies are doing well, they are happy to keep their money in these funds,” said Field.
The latest investor confidence survey by State Street Global Investors reinforced this view. While confidence among North American investors slumped more than 11 points in July, the index for Asia slipped just 0.5 points, to 83.5.
Another portfolio manager at a major global investment fund in New York also warned that cash bond spreads were no longer reliable indicators of emerging market sentiment, due to the many sovereign bond buy-backs among in recent years.
“This means credit derivative spreads are more indicative, but because they had been so resilient in previous months, these instruments had been used for cross-hedging US corporate credit portfolios or equity portfolios. Now that’s looking like a very expensive hedge,” he said.
The manager is confident that increased volatility will not prevent fresh inflows to both his foreign and local currency debt funds, especially from institutional investors. “The asset class is still grossly underallocated from a global asset standpoint,” he said.
Spreads on the JP Morgan EMBI index widened by around 70 basis points to 220bps in the latest bout of volatility, while the MSCI equity index for emerging markets lost around 9%, ending flat for the month of July. By contrast, the UK FTSE-100 index erased its gains for the whole of 2007.