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Investing in emerging markets as US raises rates – not for the faint-hearted

The economic and political situation in Turkey has recently been dominating the headlines. The Turkish lira plummeted and yields on the country’s sovereign bonds reached record highs. The country’s central bank did not do much to stop the rout, and financial markets globally are bracing for the worse.

It is no surprise that when markets sell-off risky assets lead the way down. The magnitude in emerging markets may be bigger, given some countries’ structural weaknesses, ongoing trade tensions and an increasing stock pile of US dollar denominated debt – at a time when US interest rates are moving higher.

It is no news that investing in emerging markets is generally a risky business. However, it is only fair to say that many emerging markets’ investors were caught off-guard this year, following last year’s stellar performance. Both equities and bonds returned double-digit returns during 2017 with the MSCI Emerging Markets Index gaining ­­38 per cent.

The same does not hold true this year, as the same index is down by just over 10 per cent since the beginning of the year, and down by 8.5 per cent over the past three months. Early in the year, investors fled emerging market on the back of escalating trade tensions. As market volatility increased, investors sought shelter in the US dollar. In addition, upbeat US economic figures and the ensuing monetary policy in the US increased demand for the greenback, and as a result increased the probability of economic dangers for some emerging markets.

Among the developed nations, the US economy is in the best shape. Economic growth is rising at a solid rate, unemployment rate declined and household spending picked up.

In this market scenario, inflation sets in and central bankers usually embark on a monetary policy programme where short-term rates are revised higher to reduce the possibility of the economy overheating. In fact, since December 2015, the US Federal Reserve raised interest rates six times. On the one hand, this is good news for US businesses, their trade partners and the country’s citizens. On the flip side, emerging market countries with huge debt denominated in USD may be among the losers from higher interest rates.

Following the years after the 2008 financial crisis, investors sought higher returns in emerging countries as the interest rates differential between developing and developed nations widened. In the process, dollar-denominated bonds issued by emerging markets’ non-financial corporates increased from just over 61 per cent of GDP in 2008 to 102 per cent in 2016, according to the Bank of International Settlements.

Many emerging markets’ investors were caught off-guard this year following last year’s stellar performance

With the US Federal Reserve on track to raise rates twice by the end of the year, the outlook for some emerging markets looks bleak. The current monetary tightening in the US could have huge negative impacts on emerging economies. The significant rise in debt raised by corporate borrowers is a big cause of concern. The sharp increase in US denominated debt by emerging countries make these countries more vulnerable to global shocks. In addition to higher US rates, in a market environment where volatility is on the rise, demand for the US dollar is expected to increase, making the situation even more difficult for emerging markets.

During a period of increasing risk aversion, fire-sales set in and as investors flee risky assets, the good credits or countries with sound fundamentals tend to get caught in the middle of the storm.

In terms of equities, on a price-to-book basis, emerging market equities are trading very close to their 10-year averages. Hence, investment analysts believe that opportunities do exist in the emerging markets space, yet investors should navigate this market with caution.

Emerging market bonds and equities are expected to generate volatile returns, hence it is strongly advisable that going forward investors are selective. Holding an exchange traded fund, or a passive investment which tracked the emerging markets space, had worked wonders last year. The same could not hold true for the next few years. Being selective through an active investment fund which can differentiate between high risk and lower risk companies should generate better risk-adjusted returns.

Moreover, less than perfect market information makes emerging markets an asset class subject to mispricing and therefore an area where active management can add value to investors, as the strategy takes advantage of opportunities when they occur. In addition, markets should no longer perceive emerging economies as a homogenous group of low-growth-highly-indebted nations.

Because some emerging countries have strong fundamentals, analysts do not foresee a widespread emerging debt crisis, as the US moves forward with higher rates. However, countries with large US dollar denominated debt and fragile macroeconomic conditions are most likely to be the hardest hit. In the process, as some investors are busy exiting the asset class, investment opportunities may arise. At this stage invest in emerging markets only if you understand the benefits of the asset class in a diversified portfolio, and if you have a long-term investment time horizon.

Surely, investing in the equity and markets of emerging economies is not for the faint-hearted particularly if one cannot withstand sudden and sharp ups and downs.

This article was prepared by Gabriel Mansueto, branch manager and senior investment advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410, or e-mail gabriel.mansueto@jesmondmizzi.com.

www.jesmondmizzi.com

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