28th January 2014
Jan Dehn, Head of Research at Ashmore, discusses below how an unprecedented spike in correlations between US real rates and Emerging Markets (EM) spreads reflects the current taper tantrum and a general simplification in the way the market trades EM. Once again, Mindful Money has decided to publish the full note, in the belief that if you as an investor are very concerned about your asset allocation, you will want to hear the full explanation from the experts.
“We think EM markets are over reacting to Fed tapering and that the reaction has been far too indiscriminate. Or put differently, there is some serious dumbing down going on in financial markets right now when it comes to EM. EM debt levels (especially external debt), EM’s general reliance on external markets, and EM’s reserve holdings have all improved beyond all recognition over the past ten years.
“We know that markets are still extremely bad at valuing the EM assets class during periods of general policy uncertainty. We know that asset price volatility sometimes spikes far in excess of what is justified by fundamentals in EM. On the other hand, we believe this means that there is great opportunity now. Indeed, all big generalised EM sell-offs have proven to be excellent buying opportunities. Correlations tend to temporarily increase sharply only to collapse later and in retrospect such spikes have always proven lucrative for value investors in EM.
“More sophisticated investors recognise this. They prefer to buy when things are cheap. However, investors should resist the temptation to buy into the current weakness in a simplistic contrarian fashion. After all, not all credits are alike. Some EM credits are very weak and in some cases the decline in their asset prices is entirely justified. Yet, the weakest credits can also sometimes be the very best buys. Identifying value is a complex exercise. Turning points are hard to identify. Decide how much you want to buy. Divide your purchases into little bite sized pieces and begin to nibble. Keep your engagement active with a strong credit focus.
“Turning from the general market to China, much attention is being paid to an alleged imminent default on a so-called investment trust product offered by ICBC, a Chinese bank. We have no comment on the specific product or the bank, but we do believe that the significance of the investment trust issue is being blown out of proportion, probably due to widespread ignorance about the nature of the trust sector in China.
“Turkey grabbed headlines this week when the central bank offered one tenth of its FX reserves in a single day of FX intervention with little effect on the currency. The intervention followed a tightening of liquidity conditions in the domestic market (but a reluctance to raise actual interest rates).
“A word on Argentina. “Peeing in your pants to keep warm” is Danish expression to describe short-term measures that provide temporary comfort, but ultimately leave you worse off than if you had not taken the measures at all. Last week, the government of Argentina peed in its pants to keep warm by allowing its currency to weaken sharply and introducing small measures to ease capital controls. But the government did sufficiently address the underlying excess demand problem.
“Retail sales in Mexico firmed strongly in November after a strong print in October. The Mexican upswing has three important drivers: Strong reforms undertaken last year, a Mexico specific cyclical upswing, and a marginally faster US growth rate in 2014 compared to last year.
“The business cycle in Russia appears to be turning after having lagged the rest of EM in H2 2013. Industrial production rose 4.3% mom sa in December. We do not think Russia’s economy is about to take off in a dramatic fashion, but a gentle cyclical upswing in 2014 should allow Russia’s growth rate to double to 3.0% in 2014 from last year’s sluggish 1.5%.
“The need to raise productivity in Brazil is becoming more and more obvious. It manifests itself in various ways, such as relatively elevated inflation rates in spite of slow real GDP growth. Business investment is simply far too low, and this is entirely a self-inflicted problem attributable to low quality economic policies.
“Global sentiment deteriorated sharply last week. One of the obvious risks going into 2014 was a broader correction in the US equity market following a very strong rally in 2013. This risk now appears to be unfolding. It is now going to be important to see how sensitive the US Federal Reserve will be to weakening sentiment. The other thing we noticed was that the global manufacturing outlook now looks to be turning again. After some six months of general upturn in manufacturing the data from last week was distinctly more mixed.
“While some countries are still experiencing strong expansion others are now beginning to disappoint relative to expectations. Among the latest to disappoint were the United States and China whose PMI reports both undershot expectations. Of course, the market chose illogically to pay far more attention to China because it is an EM country. On the other hand, PMIs were strong in Europe, while industrial production rose sharply in countries such as Russia and Singapore.
“At the end of the day, we do not assign too much importance to PMI numbers. They matter more as drivers of short-term sentiment than as predictors of growth over the cycle. Besides, PMI cycles have reflected temporary demand shocks and resulting inventory adjustments far more than capex spending intentions since 2008/2009.”