Investing in emerging markets as US rates rise

How do you take advantage of a sector that can be risky and difficult to access? Here we explore what to look for when assessing whether an emerging market is a compelling investment opportunity, and ask two of our experts to share how they are positioning their funds around events in emerging markets and the US.

The drivers underlying recent global share market wobbles are starting to feel repetitive. Investors are reacting to dips in commodities prices, any signal of faltering Chinese growth and any uncertainty over US interest rates.

These jitters have particularly stung emerging markets, where our experts forecast over one third of foreign direct investment will have been withdrawn by the end of 2015. While the flight of capital is likely to continue throughout 2016, it’s important to note not all emerging markets will face the same fate and there are some excellent investment opportunities to consider in this environment.

Watch out for emerging markets experiencing a reversing cycle

Right from the beginning of the emerging markets growth era in the mid 1990’s, we saw a ‘virtuous cycle’ emerge in commodities exporting investor favourites such as Brazil. Many of these emerging markets attracted sizeable foreign direct investment for well over a decade.

The Virtuous Cycle

In hindsight, we can see the trouble facing many of these emerging economies today is that self-reinforcing cycle allowed credit growth to get ahead of itself. As foreign investment flowed into the money supply, Gross Domestic Product inflated which in turn shrank budget deficits, increased credit ratings and attracted even more foreign investment.

This cycle has been turbocharged with ‘quantitative easing’ in recent years, where the developed world responded to the GFC by increasing the prices of defensive assets such as bonds, therefore pushing investors towards growth assets like property, shares and emerging markets.

Commodity-rich emerging countries boomed and an oversupply of commodities has now been created. And as the world has seen this commodity glut grow so too has it seen the turning of the virtuous cycle into a ‘vicious’ cycle:

The Vicious Cycle

A country-driven approach to shares yielding the best results

But it’s not all doom and gloom for the savvy investor. Emerging Markets Fund Manager at J O Hambro Capital Management, Paul Wimborne, says while countries such as South Africa and Brazil have passed their investment prime for now, China, Korea and Taiwan could be host to substantial returns. How does he differentiate between the two groups? Current account balances.

“Capital flow remains a key driver of emerging markets at the moment and that is not a good thing,” says Wimborne.

“In the face of outflows, countries that have borrowed a lot over the last few years and rely on debt are going to find it increasingly difficult to finance their deficits.

“There’s only two ways out for debt-laden countries. The first is to export your way out, which is difficult given many emerging markets are primarily commodities exporters. The other is to shrink imports, which is an incredibly painful rebalancing process for an economy to go through,” he said.

Wimborne, who co-manages the BT Global Emerging Markets Opportunities Fund, takes a top down, country-driven approach to investing in emerging markets.

“India is a great example of what we’re looking for right now, the rebalancing process took place in 2012. Domestic demand shrunk and can now start to grow again, particularly
with a reform minded Government in place.

“The only thing holding us back from a greater weighting to India is valuations of many of these companies,” he said.

Once a country has passed the current account balance quality check, Wimborne will pick specific stocks positioned to outperform. Here’s what he looks for at a company level.

“Globally, most of the companies we are investing in have strong balance sheets, won’t get troubled by the rising US dollar or rates and have positive exposure to a US recovery. We are favouring manufacturing exporter stocks like Samsung Electronics.

“We currently hold less than half of the countries in the MSCI Emerging Markets Index and have a significant exposure to China, Korea and Taiwan,” he said.

Interest rate moves creating great opportunities in currency

Variations in interest rate action across the world are also creating investment opportunities. BT Investment Management’s Head of Income & Fixed Interest, Vimal Gor, says the US dollar is a great long-term currency play.

“We’re in a world where the US Federal Reserve is raising rates while domestic conditions in emerging markets are worsening. The response from the central banks in emerging markets of course has been to cut interest rates.

“But if the Federal Reserve is hiking while emerging markets are cutting, the interest rate differential will appreciate the US dollar further while some emerging markets currencies will continue to depreciate,” he said.

There has been a significant sell off in emerging markets currencies, led by the Brazilian real depreciating 45% over the last 18 months.

Given a significant proportion of emerging markets debt was borrowed in US dollars, Gor believes these rate moves from the central banks will only accelerate the vicious cycle. How far can it go? The market is pricing in three rate hikes from the US Federal Reserve in 2016. Gor disagrees.

“The US economy will not grow strongly enough to warrant that many rate hikes, which would really turbocharge appreciation in the currency. There is just as much of a chance of rate cuts in 2016, or the year after.

“Even without further hikes, now the cycle is in play the US dollar is likely to strengthen materially, unless of course their central bank moves to stop it,” concludes Gor.