Investors are, by and large, still bullish on both emerging market debt and equity, despite a bout of extreme volatility this May, which brutalized the latter. But they’re likely to focus on markets with strong fundamentals and vibrant domestic as well as export markets as harsher liquidity conditions loom on the horizon. This was the picture that came to light in an Emerging Markets survey of emerging market investors and global fund managers.
The clearest consensus was on the biggest risk to emerging markets: a slowdown or recession in the United States. This is seen as highly likely when the housing bubble corrects and as the US’s twin deficits unwind. The slowdown would hit countries exporting to the US, put the brakes on commodity prices and increase risk aversion among global investors. “It would have the most destabilizing effect in the long-term,” says Eric Baurmeister, head of emerging market debt at Morgan Stanley Investment Management.
Harsher liquidity conditions as a result of further interest rate hikes in the United States came a distant second, and were seen as less likely than an economic downturn. However, Cliff Quisenberry, director of research at Parametric Portfolio Associates, thinks stagflation – slowing growth and high inflation – is a possibility, albeit a narrow one.
Jerome Booth, head of research at Ashmore Investment, says: “It’s an outrage that people talk about a crisis in emerging markets when … the problem is excesses in developed markets.”
Oil prices
Higher oil prices are not ruled out, but will have a mixed effect on the asset class. The MSCI emerging markets index is split evenly between oil exporters and oil importers, points out Alia Yousuf, portfolio manager at Standard Asset Management. Emerging markets have adjusted to oil prices of $70 plus relatively easily, she adds, with oil exporters benefiting from a windfall after making conservative assumptions about oil prices in their budgets.
The biggest changes in managers’ allocations took place during the sell-off in May. During the recovery, investors were more selective by country and stock, stepping up their allocation to safe credits that were not affected by the market volatility.
Fund managers are snapping up illiquid securities, such as private placements, short-term debentures and loans.
Since the fundamental outlook for emerging market commodity producers is highly favourable, there is little doubt about the credit picture in these countries. Investors are piling into investments that offer good credit stories and have very low levels of liquidity, in order to escape the expected spike in volatility.
Neil Gregson, head of emerging markets at Credit Suisse Asset Management, increased equity holdings in Brazil, Russia and outperforming speculative markets in the Middle East. Gary Topp, director at Nomura, shifted further into Asian technology and pharmaceutical equities companies that depend on global, rather than emerging markets, cycles. He is also increasingly using derivative strategies to employ short strategies in equities.
China’s growth offers opportunities to shield investors from emerging markets cycles. The highest return, and riskiest, type of equity investment is in “dynamic, small and medium private enterprises”, according to Yang Liu, director of Atlantis Investment Management in Hong Kong. She has raised her holdings in these types of firms since the start of the year, but cautions that the biggest risk in China is the “mentality” of the government, and knowing “why they want to protect this sector or encourage that sector”.
Although the May sell-off affected mainly stock markets, investors nonetheless shifted to more liquid forms of debt in countries with higher credit ratings, notably Russian sovereign debt, and Asian corporate. Local markets with strong fundamentals also looked more attractive. Helene Williamson, head of emerging markets at Foreign & Colonial, says that local currency will be “at the forefront” in 2007. Local currency debt in key Latin American markets, including Mexico and Brazil, was more attractive than external debt.
Confidence
Investing advice for the year ahead was dominated by confidence in the big emerging markets with growing domestic markets, especially the BRICs (Brazil, Russia, India and China), and oil and gas exporters Russia and Nigeria. Russia in particular is experiencing strong consumer demand, and growth in banking and telecoms, as well as a very strong external position. It is the strongest market for both debt and equities.
On equities, Mark Mobius, Managing Director at Templeton Asset Management, says that South Korea, China, Taiwan, South Africa, Brazil, Turkey and Russia all had strong companies that “present excellent investment opportunities” in both debt and equity.
Parametric’s Quisenberry offers a contrary view: investors should look to smaller emerging markets that are less correlated to developed markets, to shield themselves from a downturn in the US economy.
However, some fund managers voiced scepticism about emerging market debt. “You could see why one could make the argument that the emerging markets trend is coming to an end,” says one director. “It’s a valuation argument. We’ve priced in all the good news, so it’s much harder to get into emerging markets now. We’re unlikely to see global fund managers coming in at the same pace.”
Thomas Halvorsen, director of AP Fonden 4, a Swedish pension fund, decided earlier this year not to diversify his holdings into emerging markets. “The discount for emerging markets has never been so small ... we’re eager to invest but we’ll wait for a better opportunity.”