“Emerging Markets” have been a popular topic in recent months and a lot of prominent commentators have weighed in with their opinion. It’s an interesting topic and one which has quite a lot of relevance to us here in Australia, so I thought I’d weigh in with my own thoughts.
Firstly, I get quite frustrated that emerging markets are typically referred to as this one homogenous group like “stocks” or “bonds”. But it is easy to slip into that mindset as this commentary shows. Let’s start with a bit of perspective…
What are “emerging markets”?
According to Investopedia:
“An emerging market economy is one in which the country is becoming a developed nation and is determined through many socio-economic factors. An emerging market economy is a nation’s economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.”
“Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be on par with advanced economies, but emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency.”
Not exactly the most enlightening definition – “a developing market is not a developed market”.
As far as I’m concerned, a key feature separating developing and developed economies is what I like to call “social capital” – features such as a well-developed legal system that upholds property rights, quality education institutions, transportation infrastructure, health care. Long-term sustainable economic growth is dependent on a society with a sustainable basis for investment and development.
In terms of specific examples, the constituents of MSCI’s Emerging Markets Index is a useful guide:
Although emerging markets certainly have some similarities, it’s clearly unfair to bundle all the above countries together as if they were the same. Greece and China – we cant really call them the same?
To start from a general viewpoint, emerging market economies have experienced significant growth in economic activity and international trade over the last 25 years. For our northern neighbours in Asia, growth has been the result of outward-oriented strategies focused on very strong expansion of trade both within their own region and throughout the wider world. Similarly, South American emerging markets have been driven by demand for primary and industrial commodities and fuelled by the development of trade policies that opened the door to a global marketplace. European emerging market economies have broadly been the beneficiary of political measures that have seen many move towards functioning market economies from their socialist past.
So in essence, “globalisation” has been the key driver of emerging markets performance in the past 25 years. Within this, we can identify some key conditions under which emerging markets in general tend to perform well:
Positive global growth outlook
Low interest rate environment
Stable currency – particularly USD
Up until this year these key conditions existed and although emerging markets tend to be more volatile, they have outperformed developed economies over time.
Emerging markets as an asset class have performed well owing to their strong economic growth within a world of near-zero interest rates. The world has been awash with capital seeking yield and emerging markets have been a beneficiary. Some has come from foreign direct investment – capital invested in factories, property and companies. Additionally, emerging markets have found tremendous demand for bonds and have issued mountains of debt to yield-hungry investors.
But issuers perhaps made a “mistake” with issuing this debt. The view is that investors weren’t too interested in having debt denominated in some developing economy currency, so much of the debt issued was denominated in USD or other foreign currency. Unless prudent hedging strategies are enacted, any reduction in the value of their currency will therefore see their debt burden increase (potentially drastically).
It’s estimated that over $200 billion of USD-denominated bonds and loans, issued by emerging market governments and companies will come due over the remainder of this year. About $500 billion will come due in 2019. Through 2025, emerging market governments and companies face $2.7 trillion in USD-denominated bonds and loans that will come due and have to be paid off or refinanced. In addition, there’s a substantial amount of euro and yendenominated debt.
Turkey has been a major focus within recent emerging markets turmoil. Part of the reason is because according to Bank for International Settlements data USD-denominated debt issued by non-bank borrowers stood at around 23% of GDP at the end of 2017! A general trait of emerging market economies is lower debt levels compared to developed markets – although 23% doesn’t sound like much to us in developed nations who are used to debt figures much higher, for an emerging market this number is pretty high.
This is the centre of the “emerging markets are doomed” thematic – that rising US interest rates and correspondingly a rising US dollar spells doom for emerging markets, especially those that have high debt denominated in USD.
I don’t dispute that a rising USD and interest rates is not a positive, but a little historical perspective is warranted…
Rising USD and interest rates get rolled out every time there is some EM blow-up. There’s been plenty of incidents in the last 20 years going back to the 1997 Asian Financial Crisis. And the reaction from the financial media has become pretty predictable.
It starts with some sort of incident (Turkey being the main one this time). A crowd of onlookers emerge, all interested to learn what is going on (we can partly blame the financial news media for this in their quest for constant “content” to fill their broadcasts). People who really don’t know what’s going on start to explain what’s going on. “Emerging Markets Experts” appear on Bloomberg positing that the incident might spread. The focus becomes the prospect of “contagion” with little attention paid to the original issue. Often, whilst everyone is distracted by the “contagion” risk, the initial problem has quietly disappeared.
The thing is – if you had carefully bet against all the doom and gloom associated with other recent blow-ups, you’ve made a lot of money.
Rising US rates and a strong dollar haven’t spelled the end of emerging markets in prior blowups. In terms of debt levels, it’s also important to consider who owns it. It’s understood that it’s common for emerging market countries to internally transact in USD – in other words, a pile of foreign denominated debt doesn’t necessarily mean that the lenders are foreigners. This makes a real difference – yes, a rising USD makes the debt burden greater for the borrower, but the lender gains as the local currency value of their asset grows. Yes, the risk of default still grows but when any default would be settled internally it’s not cause for international concern.
Yield-hungry international investors tend to be a pretty forgiving bunch. Even in the event of major defaults, it doesn’t mean that the borrower is locked out of debt markets – there’s nothing like a purge in debt to make a viable entity (or country) vastly more creditworthy!
This is where we start to diverge from treating all EM economies the same. Internal economic factors matter.
In summary, I don’t believe the recent blow-ups in Turkey and Argentina spell doom for all emerging markets. “This time” could be different, but I just don’t see too many dramatic differences compared to all the past blow-ups that have typically presented buying opportunities.
Where are the opportunities?
When you stop thinking about “emerging markets” as a homogenous group and start looking at individual countries, opportunities begin to emerge. Say a country had GDP growth that looks like this:
And a share market that looks like this:
GDP growth that’s averaged around 7% and a market down 30%? In a world still plagued by low growth, you’ve got my interest!
Like a lot of investing, your time horizon will matter. Longer-term, we’re thinking about which countries will be “developed markets” of tomorrow? Have countries used their time wisely during the recent globalisation phase to work on institutional reforms and the development of their economies into something resembling a “developed” market?
Short-term, well, sentiment is a key driver. Providing you’re confident an asset is still going to exist in the future, buying when sentiment towards it is very negative is usually a winning strategy.
Emerging markets are somewhat of a haven for traders owing to the higher volatility that they often display compared to developed markets. And with long-term growth prospects that are the envy of the developed world (there we go slipping back into the “generalisation” mindset), there’s some amazing winners for the stockpickers.
One word of caution – remember that if you think there’s opportunity on the short-side, choose your instrument and market carefully – shorting a currency with high interest rates can cripple you on the holding cost if you are paying 10% interest!
This is undoubtedly a feature in some of the recent action – there’s a point where the carry trade yield-hunters (traditionally the Japanese, but more global these days) endure too much pain on their longs and repatriate their capital, exacerbating selling pressure but not necessarily having any fundamental impact – when things look stable, a new pool of yieldhunters will be waiting to take advantage of high interest rates.
Disclosure – Aviator presently does not currently hold any direct positions – short or long – in anything you would categorise as an emerging market. We did have emerging market exposure after the GFC, when there was a very good buying opportunity. Right now, we hold positions in Australia and with Australia’s dependency on China for economic prosperity, you could say we hold emerging market positions through our exposure. Australia is sometimes considered a proxy for emerging markets due to our regional location, exports, and trade – albeit it with better regulation, market depth and economic stability
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
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Emerging Markets
Emerging Markets
“Emerging Markets” have been a popular topic in recent months and a lot of prominent commentators have weighed in with their opinion. It’s an interesting topic and one which has quite a lot of relevance to us here in Australia, so I thought I’d weigh in with my own thoughts.
Firstly, I get quite frustrated that emerging markets are typically referred to as this one homogenous group like “stocks” or “bonds”. But it is easy to slip into that mindset as this commentary shows. Let’s start with a bit of perspective…
What are “emerging markets”?
According to Investopedia:
“An emerging market economy is one in which the country is becoming a developed nation and is determined through many socio-economic factors. An emerging market economy is a nation’s economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.”
“Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be on par with advanced economies, but emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency.”
Not exactly the most enlightening definition – “a developing market is not a developed market”.
As far as I’m concerned, a key feature separating developing and developed economies is what I like to call “social capital” – features such as a well-developed legal system that upholds property rights, quality education institutions, transportation infrastructure, health care. Long-term sustainable economic growth is dependent on a society with a sustainable basis for investment and development.
In terms of specific examples, the constituents of MSCI’s Emerging Markets Index is a useful guide:
Although emerging markets certainly have some similarities, it’s clearly unfair to bundle all the above countries together as if they were the same. Greece and China – we cant really call them the same?
To start from a general viewpoint, emerging market economies have experienced significant growth in economic activity and international trade over the last 25 years. For our northern neighbours in Asia, growth has been the result of outward-oriented strategies focused on very strong expansion of trade both within their own region and throughout the wider world. Similarly, South American emerging markets have been driven by demand for primary and industrial commodities and fuelled by the development of trade policies that opened the door to a global marketplace. European emerging market economies have broadly been the beneficiary of political measures that have seen many move towards functioning market economies from their socialist past.
So in essence, “globalisation” has been the key driver of emerging markets performance in the past 25 years. Within this, we can identify some key conditions under which emerging markets in general tend to perform well:
Up until this year these key conditions existed and although emerging markets tend to be more volatile, they have outperformed developed economies over time.
Emerging markets as an asset class have performed well owing to their strong economic growth within a world of near-zero interest rates. The world has been awash with capital seeking yield and emerging markets have been a beneficiary. Some has come from foreign direct investment – capital invested in factories, property and companies. Additionally, emerging markets have found tremendous demand for bonds and have issued mountains of debt to yield-hungry investors.
But issuers perhaps made a “mistake” with issuing this debt. The view is that investors weren’t too interested in having debt denominated in some developing economy currency, so much of the debt issued was denominated in USD or other foreign currency. Unless prudent hedging strategies are enacted, any reduction in the value of their currency will therefore see their debt burden increase (potentially drastically).
It’s estimated that over $200 billion of USD-denominated bonds and loans, issued by emerging market governments and companies will come due over the remainder of this year. About $500 billion will come due in 2019. Through 2025, emerging market governments and companies face $2.7 trillion in USD-denominated bonds and loans that will come due and have to be paid off or refinanced. In addition, there’s a substantial amount of euro and yendenominated debt.
Turkey has been a major focus within recent emerging markets turmoil. Part of the reason is because according to Bank for International Settlements data USD-denominated debt issued by non-bank borrowers stood at around 23% of GDP at the end of 2017! A general trait of emerging market economies is lower debt levels compared to developed markets – although 23% doesn’t sound like much to us in developed nations who are used to debt figures much higher, for an emerging market this number is pretty high.
This is the centre of the “emerging markets are doomed” thematic – that rising US interest rates and correspondingly a rising US dollar spells doom for emerging markets, especially those that have high debt denominated in USD.
I don’t dispute that a rising USD and interest rates is not a positive, but a little historical perspective is warranted…
Rising USD and interest rates get rolled out every time there is some EM blow-up. There’s been plenty of incidents in the last 20 years going back to the 1997 Asian Financial Crisis. And the reaction from the financial media has become pretty predictable.
It starts with some sort of incident (Turkey being the main one this time). A crowd of onlookers emerge, all interested to learn what is going on (we can partly blame the financial news media for this in their quest for constant “content” to fill their broadcasts). People who really don’t know what’s going on start to explain what’s going on. “Emerging Markets Experts” appear on Bloomberg positing that the incident might spread. The focus becomes the prospect of “contagion” with little attention paid to the original issue. Often, whilst everyone is distracted by the “contagion” risk, the initial problem has quietly disappeared.
The thing is – if you had carefully bet against all the doom and gloom associated with other recent blow-ups, you’ve made a lot of money.
Rising US rates and a strong dollar haven’t spelled the end of emerging markets in prior blowups. In terms of debt levels, it’s also important to consider who owns it. It’s understood that it’s common for emerging market countries to internally transact in USD – in other words, a pile of foreign denominated debt doesn’t necessarily mean that the lenders are foreigners. This makes a real difference – yes, a rising USD makes the debt burden greater for the borrower, but the lender gains as the local currency value of their asset grows. Yes, the risk of default still grows but when any default would be settled internally it’s not cause for international concern.
Yield-hungry international investors tend to be a pretty forgiving bunch. Even in the event of major defaults, it doesn’t mean that the borrower is locked out of debt markets – there’s nothing like a purge in debt to make a viable entity (or country) vastly more creditworthy!
This is where we start to diverge from treating all EM economies the same. Internal economic factors matter.
In summary, I don’t believe the recent blow-ups in Turkey and Argentina spell doom for all emerging markets. “This time” could be different, but I just don’t see too many dramatic differences compared to all the past blow-ups that have typically presented buying opportunities.
Where are the opportunities?
When you stop thinking about “emerging markets” as a homogenous group and start looking at individual countries, opportunities begin to emerge. Say a country had GDP growth that looks like this:
And a share market that looks like this:
GDP growth that’s averaged around 7% and a market down 30%? In a world still plagued by low growth, you’ve got my interest!
Like a lot of investing, your time horizon will matter. Longer-term, we’re thinking about which countries will be “developed markets” of tomorrow? Have countries used their time wisely during the recent globalisation phase to work on institutional reforms and the development of their economies into something resembling a “developed” market?
Short-term, well, sentiment is a key driver. Providing you’re confident an asset is still going to exist in the future, buying when sentiment towards it is very negative is usually a winning strategy.
Emerging markets are somewhat of a haven for traders owing to the higher volatility that they often display compared to developed markets. And with long-term growth prospects that are the envy of the developed world (there we go slipping back into the “generalisation” mindset), there’s some amazing winners for the stockpickers.
One word of caution – remember that if you think there’s opportunity on the short-side, choose your instrument and market carefully – shorting a currency with high interest rates can cripple you on the holding cost if you are paying 10% interest!
This is undoubtedly a feature in some of the recent action – there’s a point where the carry trade yield-hunters (traditionally the Japanese, but more global these days) endure too much pain on their longs and repatriate their capital, exacerbating selling pressure but not necessarily having any fundamental impact – when things look stable, a new pool of yieldhunters will be waiting to take advantage of high interest rates.
Disclosure – Aviator presently does not currently hold any direct positions – short or long – in anything you would categorise as an emerging market. We did have emerging market exposure after the GFC, when there was a very good buying opportunity. Right now, we hold positions in Australia and with Australia’s dependency on China for economic prosperity, you could say we hold emerging market positions through our exposure. Australia is sometimes considered a proxy for emerging markets due to our regional location, exports, and trade – albeit it with better regulation, market depth and economic stability
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.