The last elections in the USA were a rude awakening for investors in Emerging Markets. Investors bet on Hillary Clinton’s victory, and the shocking results ended in a significant sell-off. Since the elections, portfolio flows have dropped sharply to the lowest level since China-related worries in August 2015. Investors have withdrawn $13bn from Emerging Markets: $5.8bn from equity and $7.9bn from debt investments based on IFF data.
Besides the elections, there are multiple drivers for the large withdrawals in emerging markets:
South Korea
South Korea is known for a business culture centered on “chaebol” where wealthy families control the companies and limit the shareholder activism. Firms that have a “chaebol” structure include Samsung (OTC:SSNLF), Hyundai (OTC:HYMPY), LG (OTC:LGEAF) and SK Group.
The recent political scandal in the country revealed that the president, Ms. Park, was involved in a corruption scheme through her friend, Ms. Choi. Despite not having any official position in the government, Ms. Choi received $65 mm from corporations for personal use. The companies paid to obtain monopoly rights, avoid sanctions and secure tax reductions. The corruption scandal led to massive protests, and at this point, it seems that Ms. Park will not step away from her post. The opposition plans to vote for her impeachment in December.
As a result of the political scandal, investors have withdrawn $120mm from the largest single country the iShares MSCI South Korea Capped ETF(NYSEARCA:EWY), which decreased NAV to $52 from $56.
Philippines
Since the election of Rodrigo Duterte, investors have been concerned with the volatile anti-American rhetoric, which raised doubts about the future of US-Philippines relations. Since August 2016, increased political uncertainty has fueled withdrawals that decreased NAV of the largest single country the iShares MSCI Philippines ETF (NYSEARCA:EPHE) to $32 from $40.49.
Thailand
Increased political uncertainty due to the death of Thai King, who was a beacon responsible for the country’s stability for the last seven years, increased volatility in the markets. As a result of the withdrawals, NAV for the largest single country the iShares MSCI Thailand Capped ETF (NYSEARCA:THD) decreased to $70.38 from $75.98.
Since the failed coup in July, Turkey has been in a state of emergency. The latest arrests of members of the opposition have led investors to question whether Turkey is truly a democratic country. Because of these arrests, the European Parliament voted to suspend negotiations with Turkey on its EU membership. As a consequence of the withdrawals, NAV for the largest single country the iShares MSCI Turkey ETF (NYSEARCA:TUR) decreased to $32.46 to $45.97.
Why should we expect further withdrawals in the near future?
Protectionist Policy
Investors are concerned about the expected tariffs on Chinese and Mexican imports at a rate of 45% and 40%, respectively. The primary trading partner for the two countries is the USA. At this point, it is still difficult to project whether and how the tariffs will be implemented.
Nevertheless, in Trump’s recent speech, he mentioned his plan to cancel the Trans-Pacific Partnership (TPP) which covers 40% of the world’s economy and was signed by the USA, Japan, Malaysia, Vietnam, Singapore, Brunei, Australia, New Zealand, Canada, Mexico, Chile, and Peru.
Currency Risk
Investors are concerned about the rapid depreciation of currency as that reduces the wealth of the shareholders. Since the elections, emerging market currencies have depreciated significantly.
Equity Market Performance
Since the elections, markets in the US are quite high, with the Dow Jones Industrial Average Index ((INDU), S&P 500 (SPX), and NASDAQ Composite Index (CCMP) are beating records. Investors are optimistic about Trump and the Republican-dominated Congress, who are expected to implement expansionary fiscal policy through tax cuts, increased government spending, and a friendlier business environment.
The outstanding performance of the domestic markets may fuel the sell-off of emerging markets and a reallocation of capital from emerging markets to developed markets.
Bond Markets performance
On 11/23/2016, the yield on the 10-year Treasury note increased to 2.26%, a twelve-month high. The inverse relationship between price and yield makes bonds attractive when the yield rises and prices fall.
Interest Rate Hike
Investors are making large bets that the Federal Reserve will increase interest rates during a scheduled December meeting in order to make domestic investments even more attractive. Historically, a strong dollar is negatively correlated with the price of commodities. This will have an adverse effect on the commodity export-oriented countries like Argentina, Brazil, Chile, Colombia Indonesia, Russia, Saudi Arabia, UAE, Malaysia, and Peru.
Why are Emerging Markets Good Investments in the Future?
Higher GDP growth
The emerging markets’ GDP grow at a significantly higher rate than developed markets, therefore providing the opportunity for higher returns compared to the developed markets.
Low Debt to GDP Ratio
Most emerging countries have lower debt-to-GDP ratios compared to more developed countries such as Italy, Spain, UK, and Germany. Higher GDP growth rates, combined with low debt-to-GDP ratios, mitigate reinvestment risk.
US markets are too high
- The primary driver for this outstanding performance of US markets is high expectations and not fundamentals. A strong dollar will lead to the higher price of exports, increase current account deficits and put downward pressure on the GDP growth of the USA.
- Protectionist policy, precisely the imposition of higher tariffs, will decrease the profitability of companies that depend heavily on imports.
- It’s hard to say if the market overreacted and has very high expectations that could lead to a bearish market going forward.
- Some analysts believe that the increase in the yield is temporary as they could be impacted by expectations of high fiscal spending. Other analysts believe that this was the result of selling pressure – since September, foreign private and institutional investors sold $75.48 billion in Treasuries.
- Investors should keep an eye on the Treasury yield as the pricing may reflect selling pressure. Overheated expectations over the short term may reverse in the long term.
- Nevertheless, a small increase in interest rates will not make a significant improvement in domestic fixed income securities. Once investors realize this, they will return to looking for the high yields that Emerging Markets usually offer.
- In a few months, markets will be able to price their expectations accurately, and investors will have a better understanding of US policy towards China, Mexico and other emerging export-oriented countries that will decrease volatility.
Investment Opportunities During Global Withdrawals
- Meanwhile, the high level of sell-offs presents an opportunity to add emerging market securities for a low price. Therefore, investors should keep an eye on the emerging markets for the next few months.
- An excellent opportunity for investors is the iShares JP Morgan USD Emerging Markets ETF (NYSEARCA:EMB). In the last year, the Fund significantly outperformed fixed income, the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and performed well compared to the SPDR S&P 500 ETF (NYSEARCA:SPY) equity ETF.
- Since the beginning of the year, the iShares JP Morgan USD Emerging Markets ETF had a higher yield and coupon compared to the iShares Core U.S. Aggregate Bond ETF.
- While iShares Core U.S. Aggregate Bond ETF had an average investment credit rating, the iShares JP Morgan USD Emerging Markets ETF had a non-investment credit rating, implying higher credit risk.
- The iShares JP Morgan USD Emerging Markets ETF is more sensitive to the change of yield, where 1bp increase/decrease translates to a 0.067% shift in NAV compared to a 0.049% shift in the iShares Core U.S. Aggregate Bond ETF.
Between February and September, the iShares JP Morgan USD Emerging Markets ETF was trading above the average with a small premium of NAV. After the elections, the price dropped significantly to $109.27 from $115 per share due to the withdrawals that created an opportunity to buy shares with a discount of NAV.
Why is the iShares JPMorgan USD Emerging Markets ETF a good investment option?
Currency risk eliminated
Currency risk is one of the major concerns for American investors as local currency volatility can easily wipe out shareholders’ wealth. The fund invests in bonds that are denominated in US dollars thereby eliminating currency risk.
Higher Yields
Emerging markets’ yields are greater than US yields which mean that emerging markets are a more attractive investment.
Low-risk of default
The fund invested a significant portion in sovereign debt (80.92%) and only a small fraction of the agency debt (18.96%). Based on CDS spreads, markets believe that Greece (no positions in the fund), Venezuela and Ukraine have the highest probabilities of default.
Venezuela
The economy is highly dependent on exports of oil and gas, which account for 90% of exports and 32% of the GDP. The sharp decline in oil prices led to a recession, which in turn triggered hyperinflation at the rate of 500%. Nevertheless, Venezuela has a good history of making payments at the expense of their people’s welfare.
China, the largest creditor of Venezuela, offered to invest $2.2bn in Venezuela in exchange for increasing oil supply to 800,000 barrels a day compared to 550,000 in September. The fund has 2.34% of Venezuelan debt in the holdings.
Ukraine
Last year, markets strongly believed that Ukraine would default on the debt. Ukraine, however, was able to negotiate a restructuring of its debt with almost all of its lenders. Ukraine had to default on the Russian portion of its debt because of its conflict with Russia.
As of 11/11/2016, Fitch has upgraded Ukraine’s credit rating to B- from CCCwith a stable outlook. S&P didn’t change the credit rating of B-.
Moody’s has affirmed the lowest credit rating out of the rating agencies of Caa3 with a stable outlook.
The election of Donald Trump raised concerns among investors that Trump will soften sanction policies against Russia, which could then lead the escalation of conflict between Russia and Ukraine. It is difficult to identify Trump’s future policies towards Russia as there is still uncertainty over the choice of Secretary of State.
Even if Trump decides to make a welcome move towards Russia and lift the sanctions, he might have to go through Congress to implement this decision. The Republican-dominated Congress may oppose his decision.
The situation in Venezuela and Ukraine show that governments will default only under catastrophic economic conditions and that they would try to delay that default as much as possible. The combined Venezuelan and Ukrainian bonds contribute 4.44% to the portfolio and do not represent a significant source of risk for the overall portfolio.
Well-diversified fund
The diversification of issuers decreases the overall risk if the correlation is close to zero or is in the negative. The fund invests in securities from issuers from 39 countries with the largest holding of 6.23% in Mexico.
I have created an association table of the major countries that shows a small correlation and significant diversification effect if they are combined in a single portfolio.
The ten most major issuers are: Mexico (6.23%), Indonesia (5.20%), Russia (4.99%), Philippines (4.59%), Turkey (4.56%), Brazil (4.11%), China (4.06%), Argentina (3.85%), Hungary (3.67%) and Colombia (3.63%).
The bottom line:
- The US election was a catalyst for the withdrawals from the Emerging Markets.
- Increased political instability in South Korea, Philippines, Thailand and Turkey also increased withdrawals.
- As a result of the elections, emerging markets’ currencies lost their value because it is expected that protectionist policies will be enacted.
- An outstanding performance of the domestic markets increased reallocation of capital from emerging to local markets. The question arises: will the markets be bullish or become bearish in the near term?
- Investors anticipate that an interest rate hike that will lead to the further sell-off of emerging market securities. The question arises whether a 0.25% increase will improve the performance of domestic securities significantly and result in a renewed search for the high yields provided by emerging markets.
- Emerging markets are still sound investments due to their high GDP Growth and low debt-to-GDP ratios.
- Compared to the largest domestic fixed income fund, the iShares JP Morgan USD Emerging Markets ETF significantly outperforms, and this performance can be compared to the equity market in the US.
- The iShares JP Morgan USD Emerging Markets ETF invests in sovereign debt that pays in US dollars that eliminate a currency risk.
- The iShares JP Morgan USD Emerging Markets ETF is a well-diversified fund that has a lower risk compared to the single investment.
- The iShares JP Morgan USD Emerging Markets ETF has a low probability of default: The experience of Venezuelan and Ukrainian debt shows that governments of emerging markets have good payment histories and only default under extreme economic conditions.
- Investment in the iShares JP Morgan USD Emerging Markets ETF is an excellent opportunity for investors to buy shares at discounted rates during sell-offs.
- In a few months, we can expect markets to stabilize and reverse the current sentiment about investing in Emerging Markets.
Andrii Taranukha is an Asset Management Analyst at Credit Suisse.
