The Fed has become very hard to read.
The turmoil emerging markets are experiencing right now can be traced back to 2010. Then, thanks to a huge stimulus from China, growth in the developing world gathered strength at a rapid pace. But that growth proved to be a bubble.
Now that China is scaling back infrastructure investment and its demand for commodities has fallen, emerging markets have seen growth slow. And as growth has slowed, we have seen the return of some misguided policymaking – Brazil’s failure to control public spending and inflation is just one of example of this trend.
So as an investor, you find yourself having to pay much more attention to country-specific risks in emerging markets. The economic prospects for the countries that make up emerging markets will diverge. That said, I don’t think emerging markets are about to enter a crisis similar to those we saw throughout the 1990s.
The reforms they have made in recent years – such as better management of their capital and current accounts and switching from US dollar to local currency government borrowing – mean they have the necessary tools to overcome the difficulties that may lie ahead. What we are seeing is a re-pricing of risk, not the beginning of a crisis.
Within developed markets, it remains difficult to secure an attractive level of yield without taking on considerable levels of risk. So although we expect interest rates to remain at historically low levels for some time and continue to see some value in high-yield bonds, we want to avoid being overly exposed to any one asset class or market. Our favoured sector in European markets is the financial sector, where both senior and subordinated debt offer attractive yields.
As I have mentioned before, I believe China will manage to pull off its planned transition to a more consumer driven economy. But this change will have consequences for emerging markets – particularly commodity exporters who used to depend on China for their growth. As such, the portfolio has for some time maintained short positions in a number of emerging market currencies and bond markets. We expect the South African rand, Chilean peso and Malaysian ringgit to be among the currencies that will depreciate further in the months ahead.
That said, there are areas within emerging markets that do offer some value. Emerging market dollar-denominated debt is one such area. Here, investors can get an attractive level of yield without the volatility that comes with currency exposure. Valuations for the asset class are attractive as many EM sovereign borrowers have been unfairly tainted by Brazil, which was recently downgraded to junk status by ratings agency Standard and Poor’s.
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