The substantial gains enjoyed by many emerging market currencies in 2007 have sent institutional investors running to step up their exposure, but analysts remain divided on whether the top of the market is already approaching, Emerging Markets has found.
Mark Farrington, who manages active currency mandates worth around $6 billion for Principal Global Investors, anticipates a correction in commodity markets leading emerging assets lower, perhaps as soon as the first quarter of 2008.
“Emerging market equities have diverged from leading indicators of the global economy, with the recent surge of retail fund money being a classic sign that the market is at a top,” Farrington told Emerging Markets.
“But cyclical global growth will slow, marginal demand for commodities, especially base metals, will fall accordingly, then eventually energy, and belatedly, all the believers in decoupling, and in China growing without the US, will capitulate at the same time, and will find little liquidity to exit their positions,” he said.
The liquidity squeeze will be accentuated by the growing use of credit, index and commodity derivatives, Farrington believes, which have “created the illusion that you can run much bigger positions than the underlying market liquidity would support.”
“There are people holding 10-12% allocations to commodities that they think they will keep throughout the cycle – this is unprecedented, normally you would move back to a zero allocation once the cycle has peaked.”
Commodities will pull major emerging equity indices lower due to the heavy weighting of commodity plays in market such as Russia and Brazil, Farrington argued, and the outflows will then weaken their exchange rates. The rise in risk aversion will begin to reverse the “largest ever decline in home bias in the Japanese and US markets” that occurred in the past year, causing those currencies and the Swiss franc to rebound further against emerging markets.
If the US and Japanese slowdowns prove a temporary dip, then he expects a financial market correction that does not contaminate the real economy too heavily. But a more pronounced downturn could lead to a “total simultaneous financial market reallocation that causes a balance sheet event big enough to knock us into a global recession,” warned Farrington.
Paul Horsnell, head of commodities research for Barclays Capital, agreed that the outlook for base metals in 2008 was weak – especially copper, which would cloud the prospects for the currencies of leading exporters such as Chile. But he is more upbeat on the prospects for oil, pointing out that the OECD countries have “barely contributed” to incremental demand for the past four years in any case.
“It is mainly a non-OPEC supply-side story – Brazil, Russia and Azerbaijan all look set to increase production in 2008, by maybe 750,000 barrels per day in total. But that will be completely offset by declines in the UK, Norway and Mexico,” he told Emerging Markets.
And for major soft commodity producers in Asia and Latin America, global food shortages and the rising production of biofuels look set to make 2008 a bumper year.
“In a recent survey we conducted, 45% now said agricultural commodities were their preferred allocation for 2008, compared with just 20% for energy” said Horsnell.
And while Farrington’s investment strategy is specifically tasked with predicting turns in financial market cycles and hedging clients’ portfolios accordingly, more conventional “trend-following” fund managers are taking a calmer view.
Robert Parker, vice-chairman of Credit Suisse Asset Management (which manages more than $600 billion), told Emerging Markets that a sharp rebound in the dollar against emerging market currencies is “not on our radar for 2008,” although the greenback might begin to recover alongside the US economy in 2009.
“We are seeing interest from Japanese investors in particular, who are not ready to return to the dollar yet, but who see the euro and sterling as overvalued, and of course want a higher return than is available on yen assets,” said Parker.
And even if commodities become “more subdued” in 2008, he noted that there was still room for the Brazilian real to appreciate, while the Gulf states were facing “the most intense pressure I have ever seen” to revalue their currencies.
“Emerging Asia also has further to gain, driven by the Chinese yuan, which we could see going to 7.0 per dollar,” he added, suggesting that China’s GDP growth would probably remain in the mid-to-high single digits, even if the US fell into recession.
He also argued that institutional investors were not becoming singificantly more conservative on emerging market credit, in view of low default and illiquidity risks in the asset class, together with a better return than at the start of 2007.
“At these levels, emerging market debt is already a buy, so we don’t see much room for further spread widening,” Parker said, although he cautioned on countries with financial sectors that relied heavily on wholesale financing, such as Turkey.
Emerging equities could take a few months to make new gains, but the market will be “in the process of forming a base in 2008,” Parker said. He noted that prospects were no longer unified across the asset class. While Chinese, Vietnamese and Indian equities had become overvalued due to bottled-up domestic savings, other Asian markets such as Thailand, Taiwan and Malaysia were still trading cheap, together with the Middle East and Brazil.
But John Cleary, managing director of Focus Capital, an emerging market absolute return fund of funds, echoed Farrington’s concerns that emerging equity funds had been marketing aggressively to a retail audience, and that many of those now buying into the asset class had “missed or misallocated” the long bull market.
Cleary also warned that most emerging market sovereign spreads were still slightly too tight to present an attractive entry point. “A pure emerging market debt fund manager may tell you otherwise, but those who have the choice of asset allocations are not yet ready to take on more exposure.”
And although he remained cautiously optimistic on Asian equities, Latin American stocks by contrast had seen “half the economic growth, and twice the market performance,” he said, leaving little room for upside.
His own fund, which has outperformed leading hedge fund indices, has adopted a large cash allocation and steered clear of EM local currency funds.
“Even in developed markets, FX management has been one of the least consistent ways of making money,” Cleary said. “And in emerging markets, there are more managed currencies than free floats, which makes future exchange rate movements more opaque.”