Global liquidity slowly ebbs. While every geography has slightly different contexts, the common element has been U.S. dollar strength, meaningful increases in long term U.S. dollar yields and concerns about imminent reversals in G3 (the United States, Japan, and the Eurozone) quantitative easing. The reversal in the United States remains ongoing and will eventually occur in the European Union and Japan as nominal growth is restored. Many years of abundant global liquidity created reasonably narrow credit spreads and low volatility, with capital looking, often indiscriminately, for yield in a yield-deprived world.
The EM bond universe is NOT the same as the EM equity universe. EM bond market country weights are completely different than EM equity market weights for a reason. EM bond market indices are by definition dominated by capital importers (structural current account deficit countries). EM equity indices are largely dominated by capital exporters (structural surplus countries, namely in Asia).
The EM equity universe is increasingly all about Asia. The North Asian “big three” MSCI EM equity country weights (China, South Korea, and Taiwan) represent almost 57% of total benchmark weights and are all capital exporters with very limited external debt. In Asia, the only meaningful capital importers are India, Indonesia and the Philippines.
EM bonds, by contrast, are all about Eastern Europe, Latin America, Africa and the frontier markets. The JPM EMBI Global Index (a benchmark EM bond index) is heavily weighted with capital importers. Eastern European countries (inclusive of Turkey) represent 25% of the EM bond index, which contrasts with just 6% of the MSCI EM equity index. Similarly, Latin American issuers are 37% of the bond index and only 12% of the equity index. Africa represents 12% of the bond index and less than 7% of MSCI EM equities. And frontier markets are heavy components in bonds, but meaningless in equity indices.
Capital exporters are better positioned for a tightening of global liquidity. The underlying point is that the overwhelming majority of EM equity markets are in geographies with excellent external balances and relatively low representation in EM bond indices. EM countries in Asia with large manufacturing trade surpluses (China, Korea, Taiwan, and Thailand) and oil exporters like Russia and the Middle East are entirely different beasts than chronic deficit countries like much of Latin America and Africa. And predictably in these geographies we have seen unusually little action in the currency markets as they are disconnected from the bigger problems emerging in EM and frontier markets with structural funding needs (current account deficits).
We don’t expect the problems emerging in places like Argentina and Turkey to be representative of broader EM equities. The EM weakness we have seen in the past two weeks is centered on countries with structural funding problems, i.e. current account deficits. The equity weights in our fund and in the EM equity index favor exporters and structural surplus countries that we believe are incredibly resilient – and in fact fund deficits in the developed world. Further, commodity exporters (like Russia) have fared relatively better and will likely continue to do so given clear supply constraints, which are supportive for prices.
So whither from here? The conditions that resulted in the weakness we have seen in places like Argentina are likely going to continue. We believe rates will continue to rise, inflation will return, and consequently we will see a meaningful retreat in global liquidity conditions. That will come hand-in-hand with rising volatility levels that have been largely absent for years. That describes a circumstance that is enormously favorable for active managers with idiosyncratic fundamental skills, rather than the momentum and passive strategies that have fared well in recent years. We are confident that the markets and companies we favor will outperform both the structurally challenged EM countries as well as the United States, which will face its own challenges as tapering continues.
Managing through decades of crises. We have built a superlative long term record in the 22 years of emerging market portfolios -- and 11 years I have been privileged to be at the helm of these strategies -- by focusing on high quality growth stocks with appropriate prices. We have spent all of these 22 years against a constant stream of economic crises, from the Asia Financial Crisis of 1997-1998 through to the commodity collapse of 2014-2016. We like volatility because it creates an environment in which skilled active managers can excel.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.