2014: The year when fact defeats fear, Ashmore’s Dehn says
Jan Dehn, head of Research at Ashmore, discusses why sell-offs in Emerging Markets often start simply because investors are ignorant about how EM will respond to changes in the global environment, such as Fed tapering.
In the face of uncertainty, investors turn to out-dated notions of EM fragility and let themselves be guided by past behaviour. Selling ensues, regardless of the state of affairs in EM. This irrationality only goes so far, however. Fact eventually defeats fear with rewards to those who pay attention to value. 2014 is likely to be the year when fact defeats fear. Meanwhile, away from EM the combination of weak payroll data in the US and the re-commencement of Fed tapering increases the risk of a stock market correction in the US, and in Europe the ECB took out further insurance against another attack from Bond Vigilantes.
Every time a major change occurs in the global macroeconomic environment the level of uncertainty temporarily rises. The rise in uncertainty prompts a few investors to inquire about the possible implications for Emerging Markets. This is eminently sensible. Unfortunately, most investors immediately latch onto pre-conceived and outdated notions of EM fragility and sell. Immediately. Notions of EM fragility are strongly influenced by past experience, often dating back as far as the Cold War era nearly a quarter of a century ago. Back then EM economies were genuinely vulnerable to developments in global variables, such as commodity markets, global sentiment, flows from developed economies, changes in US interest rates, etc. but much has changed in the intervening period and knee-jerk selling is completely irrational.
The volatility of the EM asset class – as opposed to its risk, i.e. large permanent loss – remains the single most important detractor for existing investors to add to positions in EM and for new investors considering an inaugural investment in EM.
Volatility also creates the greatest opportunities
Somewhere along the familiar journey from fear to fact that always follows change in the global environment sophisticated EM investors begin to spot opportunities. Usually EM fundamentals remain pretty solid – after all, there are more than 65 investable countries in the asset class and they are so different that no change in the global environment will ever have the same impact on all of them. Once the initial surge of outflows abates and the asset class has re-priced the mismatch between fundamentals and prices begin to become obvious. Facts begin to displace fear. Investors with good knowledge of the EM universe and a keen sense of value begin to buy, locking in great future returns soon after the market stabilises.
EM has been through this journey from fear to fact many times before, and unless EM markets start trading more rationally it will happen many more times in the future. In 2008/2009, the market wrongly believed that EM would collapse when the subprime crisis erupted. In fact, the ensuing sell-off turned out to be the biggest buying opportunity in EM for twenty years. In 2011, the market wrongly believed that EM would blow up when Greece defaulted. Instead, the irrational sell-off led to stellar returns in 2012.
Asset prices obviously told a different story. But that is precisely the point: EM asset classes re-priced sharply in 2013. The seeds have already been planted for the next EM outperformance. We expect 2014 to be the year when facts decisively defeat the fear. Performance should follow. For those are more interested in the opportunity set in 2014 keep your eyes peeled for our Market Prospects 2014, which will be published in due course.
The ECB’s response to the Fed’s latest attempt to taper
Why does the ECB get more dovish when the Fed threatens to taper? There are two reasons: one tactical, the other more fundamental. The tactical reason is that the ECB knows that the US bond market could, in the short run, push yields higher than the Fed wants. After all, this is exactly what happened last summer when the US bond market summarily dismissed Bernanke’s reassurances that tapering is not the same as rate hikes. The ECB forward guidance is intended to pre-empt any ‘contagion’ of rising yields in the US bonds markets into the European bond markets.
The fundamental reason for ECB dovishness is that Mario Draghi understands very well that Europe is in no position to stomach higher real rates (unlike EM which is already financing in local markets yields are close to 7%). The European banking system is insolvent and unlikely to be fixed any time soon. There are near-intractable political obstacles to eradicating the bad legacy assets on the balance sheets of banks in several major European countries (but not in all of them, hence the political difficulties in fixing the problem).