1st July 2016
Jan Dehn, Head of Research at Ashmore, offers the view that it is now time to ditch the fiction of risk-free developed markets. EM asset prices behaved well in response to the Brexit shock and offer potentially better risk-return characteristics. Ashmore believes that investors should accept the facts and reduce their remaining exposure to developed markets.
Minor spill-over into EM
EM economies have very limited direct trade exposure to the UK, although they could be impacted by a broader global growth shock, which we do not expect. The fact that the impact on EM fundamentals is likely to be even smaller than the impact on asset prices means that investors can make money by buying into any temporary weakness. Indeed, we expect EM to outperform developed markets for a number of reasons.
The eerie similarity with Great Depression
The situation is quite different in many developed economies, where nationalism and populism are now very evidently on the rise. Indeed, political developments in Europe and the US look eerily similar to the aftermath of the Great Depression, where the mainstream gave way to populists and then eventually cross-border conflict. The underlying causes are unresolved economic issues that fester and create voter disaffection. Mainstream politicians are jettisoned in favour of populists, but the populists have no answers either so eventually democracy itself is called into question. We are not quite at that point yet, but the direction of travel is clear enough.
As if to underline this point, last week the International Monetary Fund cut its forecast for U.S. growth to 2.2% this year, down from 2.4% in its April 2016 World Economic Outlook. The IMF cited headwinds including the strong dollar and weak investment as well as a lower potential growth rate and a smaller output gap than previously estimated. As for the UK, it seems clear that the UK economy will now enter a slump. All investment decisions involving links to the EU will be postponed, possibly for years until the UK’s new relationship with the EU is clarified. Also, given the chaos unleashed within the main political parties in the UK all investment which depends on government spending is likely to be postponed. And finally, investments that are sensitive to the economic cycle are likely to be postponed as well as FDI flows from outside the EU pending further clarity about the UK’s future.
Repeated turn to monetary support
As usual, the only backstop left is monetary support. Fed Chairwoman Janet Yellen thus issued a dovish message in her testimony to Congress last week, highlighting “considerable uncertainty” in the outlook. The probability of any rate hike between now and January 2017 is now priced at just 17%. In this environment, the market will take some comfort from the German Constitutional Court’s rejection of challenges to ECB’s Outright Monetary Transactions (OMT) programme.
Reduce exposure to DM
Given that the underlying problems are far from being resolved, it is likely that developed markets will continue to be a source of instability for global markets. Investors really ought to ask themselves if it is appropriate to continue to be heavily invested in such countries. In EM, volatility is generally expected, but in most developed economies risks are sometimes not even perceived, let alone priced. The -11.75% intraday move in GBP on Friday was a 21-standard deviation event. It is time that investors wake up to the fact that developed markets are far from risk free and that investors are simply not paid adequately. For example, between 2000 and the end of May 2016 European IG government bonds had twice the volatility of Euro-denominated EM IG government bonds, yet paid investors only half the yield.
We strongly recommend that investors face up to these facts and significantly reduce their exposure to developed markets. Risks are simply not priced and investors are not being adequately compensated. The uncertainty – economic and political – will clearly continue in the UK and other developed economies. Switching to EM IG euro- denominated bonds achieves better returns and lower volatility than European government bonds, while at the same time reducing exposure to events in Europe, because the correlation between European and EM IG euro-denominated bonds is less than 50%.