Jan Dehn, head of Research at Ashmore, discusses important developments in emerging market economies and gives a view on Janet Yellen's candidacy.
Jan Dehn, head of Research at Ashmore, discusses important developments in emerging market economies and gives a view on Janet Yellen’s candidacy.
The Chinese word for ‘crisis’ is made up of two characters; one means danger, the other means opportunity. With every week that passes the so-called emerging markets crisis of this summer looks more and more like an opportunity. Emerging markets economies are coping well with the huge technically driven outflows, while the few countries requiring adjustment have acted decisively and are beginning to see results.
Inflation has remained elusive across EM despite widespread currency weakness and relatively low policy rates in many countries. The reason, in our view, is that the global environment is fundamentally deflationary for EM. Why? Because it is characterised by high levels of risk aversion, strong preferences for allocating to ‘risk free’ developed markets, fear of currency volatility in less liquid EM markets, and generally tighter financial conditions due in part to regulatory biases against EM.
Turning to credit worthiness
Eastern Europe is still the most vulnerable region in EM as several Eastern European countries came close to believing themselves to be ‘developed’, that is, ‘risk free’ before 2008/2009. Based on this illusion these countries gorged on cheap credit, and several are still struggling with the consequences. For example, this week it became clear that, due to its current and past fiscal profligacy, Serbia will probably need to turn to the IMF for support. These days it is very rare indeed that EM countries need IMF support. In fact, EM countries are more likely to fund the IMF than the other way around. Other countries in the EMEA region that also face debt-related challenges include Hungary (household debt), Ukraine and Croatia.
We think Janet Yellen is the right choice for two reasons. First, the US needs a ‘dove’ to maintain a very easy monetary policy during the remainder of the household deleveraging process (which in our view is not over until mid-2016,). Second, Janet Yellen was the most experienced and formidable of the available candidates. She has made major contributions in many fields of economics, most notably in the literature on labour markets, where she helped to introduce concepts such as ‘adverse selection’ to explain persistent high unemployment.
Global asset allocation
We believe there are major adverse selection problems in global asset allocation. Adverse selection is the tendency for asset allocators to ‘select’ sub-optimal or ‘adverse’ investments at the expense of better alternatives. The conditions for adverse selection to occur in global asset allocation are the following:
• There must be differences in the quality of issuers
• Investors must possess less information about the quality of issuers than the issuers themselves. The technical term used to describe this state of affairs is asymmetric information
The under-allocation of capital to Emerging Markets is made worse by conventional asset management practices. Sovereign research in Emerging Markets is generally very poor. Passive management is widespread. Many investors simply do not take credit research seriously, do not want to pay for it, and opt instead to rely on ratings agencies and investment bank research both of which can be seriously flawed. To make matters worse, the use of price volatility as a proxy for the riskiness entirely fails to safeguard portfolios. Volatility is a terrible measure of risk if markets are inefficient, which they self-evidently are. Risk is large permanent loss; volatility is merely a measure of up and downward movement of prices.