Ashmore talks Turkey, and Argentina
May 11, 2018

Jan Dehn, head of research at Ashmore Group, explores why profit-taking in EURUSD has morphed into profit taking in EM foreign exchange (FX). He also looks at the situation in Argentina and Turkey.

A vicious bout of profit taking in the euro after its very strong performance versus the US dollar last year has now morphed into similar profit taking in emerging markets (EM) currencies versus the dollar, he writes. There may be some limited merit in taking profits in EM local markets. After all, our view is that EM local currency bond markets can sustainably deliver returns of 10 percent in US dollar terms per year, over the five-year period from 2017-2021, so markets have arguably got a little bit ahead of themselves in the past five quarters. For example, in 2017 EM local markets returned in excess of 15 percent in US dollar terms and they were up another 5 percent in US dollar terms at the start of this year. Hence, a pullback has now materialized and the question is what investors should do now.

Many investors with little or no exposure to the asset class have worried in the course of the last couple of years that they had missed the rally in EM. Many have been waiting for a pullback to get in. Unfortunately, deeply negative media hyperbole nearly always accompanies pullbacks in markets, which can make it difficult to muster up the courage to invest. In particular, the media loves to extrapolate from the few to the many and from the short-term developments to the long-term trends. It is moment like this, however, during bouts of violent moves in the markets, that the differences between commentators and journalists on one hand, and investors on the other, become most pronounced. While the media paints doomsday forecasts, real investors get excited by the sudden abundance of opportunities. Hyperbole, to the investor, is a blessing. It helps to increase the value of the opportunity.

Our view is that the recent pullback in EM has restored significant value and material upside potential to an EM fixed income asset class, which already looks set to significantly outperform developed market assets in the years ahead. We see nothing in the recent unwind of EM positions, which in any way changes the benign outlook for EM. Moreover, the market moves are now rapidly moving into ‘overdone' territory. Investors should be particularly careful now not to get sucked into long US dollar positions only to find themselves whiplashed within a matter of days, weeks or, at most, months. We believe that this is the time to buy EM, not to sell. Indeed, we see the current sell-off as one of the best entry points to EM fixed income in several years. While momentum may carry markets a bit lower in the next few sessions there are two very strong arguments for taking an optimistic view at this point and beginning to nibble at the opportunities.

The first reason is that causes of the pullback in EM are not really EM-related at all. Besides the profit taking motive explained above, the surge in the dollar has been supported by the rise in the ten-year US treasury yield, a temporary slowdown in growth and inflation in Europe, the geopolitical situation in Syria and Iran as well as uncertainty arising from the US government's decision to abandon free trade in favour of protectionism. More broadly, high levels of unease prevail as to where returns in developed economies are going to come from in the years ahead as the primary driver of those returns, easy money, is withdrawn. Uncertainty often creates temporary demand for the US dollar. None of these developments is EM-related. 

So how long can these conditions be expected to weigh on EM sentiment? Tough to say with any precision. However, it is abundantly clear to us that the bounce in the US dollar is not sustainable. First, investors are already very long US dollar assets. Second, the US economy is running at full employment and accommodation is being withdrawn, so the growth outlook is uncertain to negative. Third, even the very modest rise in ten-year yields to 3 percent, which, against a backdrop of 2 percent PCE (personal consumption expenditure) inflation, hardly constitutes a harrowingly high real yield is already impeding the US stock market rally. Most importantly, the US can only finance its ballooning fiscal deficit without hurting the stock market through materially higher real yields if it places the majority of bonds with foreign central banks – and that requires a lower dollar.

The second reason for being optimistic about EM here is that the case for investing in EM remains extremely solid. Valuations are very good. For example, the real yield on offer for 85 percent investment grade, five-year government bonds in EM, that is, the local currency bond market, is now close to 300 basis points (bps, a bp is one-hundredth of a percentage point). This is not only a higher real yield than the long-term historical real yield, but also dramatically better than anything on offer in developed markets of similar credit quality and duration. The pain has mainly been in FX, not in bonds, however, which testifies to the strong technical bond position in local markets. The flipside of the currency move is that EM currencies, from current levels, have between 15 percent and 20 percent upside versus the dollar over the next three to four years, in our view. Real effective exchange rates are also very competitive. In external sovereign dollar bonds, which is an extremely diversified US$ 1 trillion asset class comprising 67 countries, the yield is now in excess of 6 percent and spreads are wide of 300 bps compared to 170 bps in 2007 before the financial crisis and 210 bps in 2010. This makes EM external debt extremely attractive, particularly versus the Barclays- Bloomberg Global Ag. Most importantly, EM markets now price in far more rate hikes than the Fed will deliver for a long time, so beyond the initial knee-jerk reaction in the market we see nothing worrisome about EM bonds from a valuation perspective if US ten-year treasury yields sit at 3 percent or even drift higher. 

EM growth is also solid. EM countries have significantly improved their external balances over the last few years on the back of rising net exports made possible through a combination of reforms, lower currencies and strong inflation discipline (EM inflation declined from 5.25 percent in 2011 to 3.2 percent today). The IMF is projecting the EM growth premium, i.e. how much faster EM countries grow relative to developed economies, to rise from 2.4 percent today to 3.5 percent by 2023 against a backdrop of outright declining rates of growth in developed economies.

 A couple of colourful EM countries, Argentina and Turkey, stand out as vulnerable, but this is entirely due to self-inflicted problems, whereas the situation in EM more broadly remains solid. Why are Turkey and Argentina in the crosshairs?

Turkey finds itself in focus because the government has been pursuing bad macroeconomic policies for a long time. Much is due to President Erdogan himself, who is keen to point out at every opportunity that high interest rates cause high inflation (he appears to have adopted this view after observing that high interest rates often coincide with high inflation). Due to this warped understanding of basic economies, Erdogan repeatedly applies pressure on the central bank to keep rates low, especially when inflation rises. The result is that inflation rises even more, that domestic credit growth is too strong and that the current account position is in a precarious state.

Argentina's problems are also entirely self-inflicted. Last week, the central bank was forced to hike interest rates dramatically to defend a rapidly weakening peso. While there is no doubt the Administration of President Mauricio Macri is a major improvement on its predecessor, the government of Cristina Kirchner, Macri's Administration made a serious mistake in December, when it raised the inflation target. In all other countries, governments would generally only consider raising the inflation target if there was a serious threat of serious deflation. After all, the point of a higher inflation target is to give the central bank room to ease monetary policies to fight deflation. Not so in Argentina. Here, the government raised the inflation target despite still running inflation in excess of 20 percent and despite having never managed to get inflation expectations under control in the first place. The underlying reason for the failure to control inflation lies with the fiscal authorities, however. They have consistently insisted on lavish spending to avoid a recession during the monetary adjustment period. However, the resulting combination of high fiscal spending and high real interest rates attracted a lot of hot money (which is now leaving head over heels), but failed to stimulate real investment since the large volumes of government debt issuance crowded out the private sector. Argentina's government has yet to get its head around the fact that demand needs to be cut dramatically if inflation expectations are to be decisively broken and the current account deficit materially reduced.

 Of all the 79 investable countries in EM, only Turkey has a president who believes that high interest rates cause inflation. Of all the 79 investable countries in EM, only the Argentinians believe that nearly two decades of excess demand stimulus can be reversed without fiscal adjustment. No other countries in EM look or behave remotely like Turkey and Argentina. Hence, to the extent that herd-like behaviour and meaningless extrapolation of the experiences of Argentina and Turkey to the rest of EM leads weaker hands to capitulate on their EM positions with the result that currencies move lower and yields move higher, this is clearly something that stronger, wiser investors should aim to exploit. 

We have seen this tendency to extrapolate from the few to the many in EM on several previous occasions. A few years ago, banks and the media latched onto the notion of the "Fragile Five", a marketing term coined by Morgan Stanley, to debunk the entire EM asset class. A few years before that Goldman Sachs coined the term ‘BRICS' to induce flows the other way. In retrospect, these gimmicks were mere marketing tools, which should never be used as a guide to investing. Indeed, buying ‘BRICS' was vastly inferior to investing in EM more broadly, and selling the ‘Fragile Five' was equally silly, since all five survived the temporary bouts of market pessimism without balance of payment crises, IMF support or defaults. It is critical, especially at times such as these, to understand that banks and media make money from short-term flows and the associated hype, while institutional investors make money from identifying value. Their interests are never further apart than during bouts of market panic.

In conclusion, investors should view the current volatility in EM markets in the right perspective. Volatility is not a new thing in EM. Do not be surprised when it happens. Not a single EM country has defaulted due to bouts of market volatility in the past 20 years, which includes some very big dislocations including the US sub-prime crisis, dotcom, the European debt crisis, etc. The drives of the current bout of risk aversion are entirely non-EM related and temporary in nature. The few vulnerable EM countries are the exception rather than the rule as the fundamental case for EM is much improved in recent years, solid in most. EM looks likely to deliver far better returns than developed economies in the coming years. Experienced EM investors expect volatility to happen. Even more experienced investors hope for it to happen, because they know it is the best time to enter the asset class. Bouts of volatility are always excellent entry points in EM and this one will be, too.

 

 





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Jan Dehn, head of research at Ashmore Group, explores why profit-taking in EURUSD has morphed into profit taking in EM foreign exchange (FX). He also looks at the situation in Argentina and Turkey.

A vicious bout of profit taking in the euro after its very strong performance versus the US dollar last year has now morphed into similar profit taking in emerging markets (EM) currencies versus the dollar, he writes. There may be some limited merit in taking profits in EM local markets. After all, our view is that EM local currency bond markets can sustainably deliver returns of 10 percent in US dollar terms per year, over the five-year period from 2017-2021, so markets have arguably got a little bit ahead of themselves in the past five quarters. For example, in 2017 EM local markets returned in excess of 15 percent in US dollar terms and they were up another 5 percent in US dollar terms at the start of this year. Hence, a pullback has now materialized and the question is what investors should do now.

Many investors with little or no exposure to the asset class have worried in the course of the last couple of years that they had missed the rally in EM. Many have been waiting for a pullback to get in. Unfortunately, deeply negative media hyperbole nearly always accompanies pullbacks in markets, which can make it difficult to muster up the courage to invest. In particular, the media loves to extrapolate from the few to the many and from the short-term developments to the long-term trends. It is moment like this, however, during bouts of violent moves in the markets, that the differences between commentators and journalists on one hand, and investors on the other, become most pronounced. While the media paints doomsday forecasts, real investors get excited by the sudden abundance of opportunities. Hyperbole, to the investor, is a blessing. It helps to increase the value of the opportunity.

Our view is that the recent pullback in EM has restored significant value and material upside potential to an EM fixed income asset class, which already looks set to significantly outperform developed market assets in the years ahead. We see nothing in the recent unwind of EM positions, which in any way changes the benign outlook for EM. Moreover, the market moves are now rapidly moving into ‘overdone' territory. Investors should be particularly careful now not to get sucked into long US dollar positions only to find themselves whiplashed within a matter of days, weeks or, at most, months. We believe that this is the time to buy EM, not to sell. Indeed, we see the current sell-off as one of the best entry points to EM fixed income in several years. While momentum may carry markets a bit lower in the next few sessions there are two very strong arguments for taking an optimistic view at this point and beginning to nibble at the opportunities.

The first reason is that causes of the pullback in EM are not really EM-related at all. Besides the profit taking motive explained above, the surge in the dollar has been supported by the rise in the ten-year US treasury yield, a temporary slowdown in growth and inflation in Europe, the geopolitical situation in Syria and Iran as well as uncertainty arising from the US government's decision to abandon free trade in favour of protectionism. More broadly, high levels of unease prevail as to where returns in developed economies are going to come from in the years ahead as the primary driver of those returns, easy money, is withdrawn. Uncertainty often creates temporary demand for the US dollar. None of these developments is EM-related. 

So how long can these conditions be expected to weigh on EM sentiment? Tough to say with any precision. However, it is abundantly clear to us that the bounce in the US dollar is not sustainable. First, investors are already very long US dollar assets. Second, the US economy is running at full employment and accommodation is being withdrawn, so the growth outlook is uncertain to negative. Third, even the very modest rise in ten-year yields to 3 percent, which, against a backdrop of 2 percent PCE (personal consumption expenditure) inflation, hardly constitutes a harrowingly high real yield is already impeding the US stock market rally. Most importantly, the US can only finance its ballooning fiscal deficit without hurting the stock market through materially higher real yields if it places the majority of bonds with foreign central banks – and that requires a lower dollar.

The second reason for being optimistic about EM here is that the case for investing in EM remains extremely solid. Valuations are very good. For example, the real yield on offer for 85 percent investment grade, five-year government bonds in EM, that is, the local currency bond market, is now close to 300 basis points (bps, a bp is one-hundredth of a percentage point). This is not only a higher real yield than the long-term historical real yield, but also dramatically better than anything on offer in developed markets of similar credit quality and duration. The pain has mainly been in FX, not in bonds, however, which testifies to the strong technical bond position in local markets. The flipside of the currency move is that EM currencies, from current levels, have between 15 percent and 20 percent upside versus the dollar over the next three to four years, in our view. Real effective exchange rates are also very competitive. In external sovereign dollar bonds, which is an extremely diversified US$ 1 trillion asset class comprising 67 countries, the yield is now in excess of 6 percent and spreads are wide of 300 bps compared to 170 bps in 2007 before the financial crisis and 210 bps in 2010. This makes EM external debt extremely attractive, particularly versus the Barclays- Bloomberg Global Ag. Most importantly, EM markets now price in far more rate hikes than the Fed will deliver for a long time, so beyond the initial knee-jerk reaction in the market we see nothing worrisome about EM bonds from a valuation perspective if US ten-year treasury yields sit at 3 percent or even drift higher. 

EM growth is also solid. EM countries have significantly improved their external balances over the last few years on the back of rising net exports made possible through a combination of reforms, lower currencies and strong inflation discipline (EM inflation declined from 5.25 percent in 2011 to 3.2 percent today). The IMF is projecting the EM growth premium, i.e. how much faster EM countries grow relative to developed economies, to rise from 2.4 percent today to 3.5 percent by 2023 against a backdrop of outright declining rates of growth in developed economies.

 A couple of colourful EM countries, Argentina and Turkey, stand out as vulnerable, but this is entirely due to self-inflicted problems, whereas the situation in EM more broadly remains solid. Why are Turkey and Argentina in the crosshairs?

Turkey finds itself in focus because the government has been pursuing bad macroeconomic policies for a long time. Much is due to President Erdogan himself, who is keen to point out at every opportunity that high interest rates cause high inflation (he appears to have adopted this view after observing that high interest rates often coincide with high inflation). Due to this warped understanding of basic economies, Erdogan repeatedly applies pressure on the central bank to keep rates low, especially when inflation rises. The result is that inflation rises even more, that domestic credit growth is too strong and that the current account position is in a precarious state.

Argentina's problems are also entirely self-inflicted. Last week, the central bank was forced to hike interest rates dramatically to defend a rapidly weakening peso. While there is no doubt the Administration of President Mauricio Macri is a major improvement on its predecessor, the government of Cristina Kirchner, Macri's Administration made a serious mistake in December, when it raised the inflation target. In all other countries, governments would generally only consider raising the inflation target if there was a serious threat of serious deflation. After all, the point of a higher inflation target is to give the central bank room to ease monetary policies to fight deflation. Not so in Argentina. Here, the government raised the inflation target despite still running inflation in excess of 20 percent and despite having never managed to get inflation expectations under control in the first place. The underlying reason for the failure to control inflation lies with the fiscal authorities, however. They have consistently insisted on lavish spending to avoid a recession during the monetary adjustment period. However, the resulting combination of high fiscal spending and high real interest rates attracted a lot of hot money (which is now leaving head over heels), but failed to stimulate real investment since the large volumes of government debt issuance crowded out the private sector. Argentina's government has yet to get its head around the fact that demand needs to be cut dramatically if inflation expectations are to be decisively broken and the current account deficit materially reduced.

 Of all the 79 investable countries in EM, only Turkey has a president who believes that high interest rates cause inflation. Of all the 79 investable countries in EM, only the Argentinians believe that nearly two decades of excess demand stimulus can be reversed without fiscal adjustment. No other countries in EM look or behave remotely like Turkey and Argentina. Hence, to the extent that herd-like behaviour and meaningless extrapolation of the experiences of Argentina and Turkey to the rest of EM leads weaker hands to capitulate on their EM positions with the result that currencies move lower and yields move higher, this is clearly something that stronger, wiser investors should aim to exploit. 

We have seen this tendency to extrapolate from the few to the many in EM on several previous occasions. A few years ago, banks and the media latched onto the notion of the "Fragile Five", a marketing term coined by Morgan Stanley, to debunk the entire EM asset class. A few years before that Goldman Sachs coined the term ‘BRICS' to induce flows the other way. In retrospect, these gimmicks were mere marketing tools, which should never be used as a guide to investing. Indeed, buying ‘BRICS' was vastly inferior to investing in EM more broadly, and selling the ‘Fragile Five' was equally silly, since all five survived the temporary bouts of market pessimism without balance of payment crises, IMF support or defaults. It is critical, especially at times such as these, to understand that banks and media make money from short-term flows and the associated hype, while institutional investors make money from identifying value. Their interests are never further apart than during bouts of market panic.

In conclusion, investors should view the current volatility in EM markets in the right perspective. Volatility is not a new thing in EM. Do not be surprised when it happens. Not a single EM country has defaulted due to bouts of market volatility in the past 20 years, which includes some very big dislocations including the US sub-prime crisis, dotcom, the European debt crisis, etc. The drives of the current bout of risk aversion are entirely non-EM related and temporary in nature. The few vulnerable EM countries are the exception rather than the rule as the fundamental case for EM is much improved in recent years, solid in most. EM looks likely to deliver far better returns than developed economies in the coming years. Experienced EM investors expect volatility to happen. Even more experienced investors hope for it to happen, because they know it is the best time to enter the asset class. Bouts of volatility are always excellent entry points in EM and this one will be, too.

 

 



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