Jan Dehn, head of research at Ashmore, explores why the end of 2016 looks very much like the end of last year, and suggests that it offers a similarly enticing entry point to EM for investors. He explores how the moves in the US markets have been overdone and that the rise in US stock markets, the Dollar and bond yields look unsustainable. He remarks that the average absolute yield in EM bonds is now higher in several themes than when the Fed had rates at 5.25% in late 2006 prior to the Subprime crisis, and that the EM growth premium will continue to rise on the back of extremely attractive real exchange rates.
At this time last year Emerging Markets (EM) were fearful of an expected hike in US interest rates the usual (and somewhat myopic) year-end position squaring. The resulting weakness in late 2015 and early 2016 was an excellent entry point that ensured strong performance for the asset class in subsequent quarters on them back of a combination of attractive yields, an improving growth picture, EM currency appreciation and very strong technicals. Indeed, investors who bought into the value created in late 2015 have had good returns in 2016, even taking into account the pull-backs in late 2016.
The outlook now looks very reminiscent of last year at this time in several respects, although there are also some differences.
- Like last year, investors have been served with an extremely enticing entry point. The pullback in EM asset prices this year has been less important compared to last year. Instead, the main driver has been sharp moves in the US dollar and the Treasury curve caused by the election of Donald Trump to the presidency in the US. We think, however, that the market reaction has been irrationally exuberant, which is why this pullback, like last year’s, is a good time to allocate. Historical experience shows that big events, such as Trump’s election, give rise to outsized moves in asset prices in EM that are typically not mirrored in worsening fundamentals. In other words, they are buying opportunities.
- The moves in the US markets are overdone with investors too complacent. The rise in US stock markets, the Dollar and bond yields look unsustainable. They price in a ‘perfect’ scenario, which, to us, is unlikely to materialise. At the most fundamental of levels, stimulating demand into a stagnant supply-side will be inflationary, which is why the long end of the yield curve is selling off. The US economy will be able to stomach such high yields, but only as long as growth is strong. This is why Trump has to increase fiscal spending. The problem, however, is that the trend growth rate in the US looks unlikely to rise materially under a populist Trump; if anything larger government deficits and trade protection will lower America’s trend growth rate. Hence, additional fiscal spending will translate into wider current account deficits and higher inflation. Remember that the economy is already close to full employment, given typical frictional unemployment and recent declines in labour participation rates. The Fed is at least eight hikes away from just reaching a nonnegative policy rate, a gap it will not be able to close without causing a recession. This is why the rapid surge in the Dollar following Trump’s election from an already overvalued level in real effective exchange rate terms does not look sustainable at all.
- There is a very strong case for EM on its own merits. The average absolute yield in EM bonds is now higher in several themes (incl. local currency government debt and high yield sovereign debt) than when the Fed had rates at 5.25% in late 2006 prior to the Subprime Crisis. The EM growth premium already started to pick up this year and looks set to continue to rise on the back of extremely attractive real exchange rates (back to 2003 levels). Technicals are also excellent. Institutional investors did not allocate in 2016, while a decent chunk of the USD 50bn of flight-prone ETF flows that flowed into EM this year has now pulled out again.
- Finally, EM debt is favourable to developed market debt in an environment of volatile US bond yields. EM bonds are unambiguously preferable for three reasons. Firstly, they have lower duration than developed market bonds, so volatile yields will have less impact on P&L. Second, EM bonds have fat yield and spread cushions that ensure given losses arising from moves in the underlying curve are offset by carry, where no such protection exists in US bonds. Thirdly, EM countries are vastly less indebted than developed economies, so that any given rise in the cost of borrowing will have a smaller overall macroeconomic impact (as a percentage of GDP).
Trans-Pacific Partnership: the irony of withdrawing
President-elect Donald Trump announced that he will withdraw the US from the Trans-Pacific Partnership, a trade agreement between the US and Asian economies, from day one of his presidency. We find this completely unsurprising, because both he and Hillary Clinton indicated that much during their campaigns. There is a heavy irony in the US withdrawal from TPP, however. The TPP was a US initiative specifically designed to limit the growing influence of China in Asia. Indeed, this was why China was explicitly not invited to participate in the agreement. The demise of TPP will therefore directly reduce US influence in Asia, leaving a vacuum, which China is certain to exploit. China is going to open its economy over the coming decades and Chinese consumption will become the most important driver of demand in the world as China’s growth shifts from exports to consumption. China’s economy will be four times larger than the US economy by 2050, but China’s consumption will rise even faster given the starting point of a 49% savings rate. As a result, China will also eventually become a net importer. It is therefore entirely rational for Asia’s exporters to shift their trade focus away from a stagnating and increasingly protectionist US towards a reforming and increasingly open China.