For a while now, talking heads have been banging the drum about a dollar liquidity squeeze.
Effectively, as the US Federal Reserve tightens rates, the better returns suck money out of higher-risk markets back to the “safe haven” of the US.
But we believe most developing markets are less susceptible to this risk than in the past. Some – like Argentina and Turkey – are vulnerable and have been hit hard recently, but overall many other developing nations should weather the storm relatively well.
We believe pockets of value are appearing in these markets, as markets have over-extrapolated from what are mainly localised issues. For most emerging market countries, current account balances are much improved from where they were five years ago, when they were roiled by the taper tantrum. Emerging market equities have reached what we would consider rare valuation levels.
Meanwhile, the average spread in yields for emerging debt markets above safe haven US Treasuries has exceeded four percentage points, what we would consider a basic “fair value” level.
Why are we here?
In Argentina, interest rates have been jacked up to an eye-popping 60 per cent (at the time of writing) in an attempt to defend the peso. The International Monetary Fund has announced its Stand-By Arrangement package of $50bn (£38bn), which takes Argentina out of the dollar bond markets for funding needs until the end of 2019.
The Turkish lira has also been plunging. President Erdoğan has assumed major new powers, such as hand-picking top public officials, being able to intervene directly in the country’s legal system and having the power to impose a state of emergency. This is scaring off foreign investors, given the huge uncertainty over how these powers may be used.
A major theme that has been weighing heavily on emerging markets is the rising dollar. But we don’t think the dollar will appreciate too much further from here – our analysis suggests it is overvalued on a number of measures and it also has several challenges to overcome. America has got to fund a ballooning deficit and that tends to weigh on the dollar, or has done historically.
Given the challenges facing the dollar and the waning reliance on dollar funding, a strong greenback is also less of a reason to avoid emerging markets than it has been previously. However, investors need to be careful in selecting countries that are less sensitive to a rising dollar, such as Mexico, Malaysia, Indonesia or China.
Some emerging market assets may be oversold
Is now the time to increase EM exposure?
We believe some emerging market assets may be oversold, and the spread in yields over safer developed market government bonds are looking attractive. To be sure, any signs of a global growth slowdown might trigger a more generalised risk-off sentiment that could delay any would-be emerging market recovery. Still, dollar strengthening due to higher interest rates cannot go on forever, and we wouldn’t write off emerging markets as a whole just yet based on these country specific issues.
Alex Moore is head of collectives at Rathbones