Emerging Markets: The Big Global Trade
The big “global trade” of the moment is the emerging markets. In a published note to clients this month, Jan Dehn, head of research at specialist emerging market investment management firm Ashmore, points to a number of factors currently playing out across global markets–and bode well for investors seeking yields in emerging markets.
Emerging market fixed income (this year) is already performing well, Dehn writes, and is being supported by what he refers to as “strong technicals” after years of excessive selling. Asset prices have moved, however emerging market fundamentals “failed to implode over the last few years despite severe headwinds–including capital outflows, the US dollar rally, falling commodity prices and monetary tightening by the US Federal Reserve.” This, he says, has created a lot of value in emerging markets. The firm states that there is “little value left in developed markets.”
It is more than just a “value trade”, Dehn says. “Brexit”, the United Kingdom’s historic vote on June 23 to exit the European Union, will “barely register” across emerging markets. In addition, there two tactical reasons for allocating to the EM’s right now. The first reason is that Brexit – a 21 standard deviation event for the GBP – pushed VIX, the Chicago Board Options Exchange Volatility Index, up by more than 10 points relative to its 60-day moving average. In the past, all EM fixed income asset classes have generated positive alpha to investors that have deliberately allocated to the asset class during episodes of 10+ spikes in VIX. The average alpha for allocations during VIX spikes is 3% in the following twelve months. This is equivalent to a 41% higher return than the average passively timed allocation.
Secondly, consideration for EM allocation now is flow-related. So far in July, emerging market bond funds have posted the largest weekly inflow on record, despite a shortened work week in the US and elsewhere, according to new data from JP Morgan. The flows were broad-based and the bulk went to actively managed funds.
This increase in flows comes on the back of strong performance year to date and proven resilience in the face of expectations of several rate hikes from the Fed this year and the volatility caused by the UK’s Brexit vote. “It is possible that EM allocations may soon become the subject of a broader momentum trade, having been out of favor for some time,” Dehn says.
Brexit Will “Barely Register” in Emerging Markets
Global financial markets are still trying to come to grips with the implications of the United Kingdom’s vote to leave the European Union. “Our view is that Brexit is overwhelmingly a UK tragedy,” Dehn writes, “but analysts have wasted little time extrapolating potential implications for the wider European arena, even for emerging markets.”
As far as the EM extrapolation is concerned, it has largely failed. After all, the UK accounts for less than 2% of global GDP, so the country’s demise will barely register in most EM countries. EM technicals are also strong, which means that there have been very few sellers. Without pregnant positions to help create momentum interest is fading in the press and among analysts.