How to benefit from increasingly heterogeneous emerging markets
22 January 2018
Although the economic upturn in emerging countries is expected to continue in 2018, all emerging countries will not be in the same boat. Whereas the growth differential between developed and emerging countries will continue to widen in favour of the latter, some countries will lag behind, marked by sluggish growth, significant deficits, a complicated political situation that does not allow them to successfully complete the necessary reforms, various geopolitical tensions, and even inflationary issues.
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Within this environment, the total return approach seems most suitable to benefit from the heterogeneity of the emerging world. Whereas long-only benchmarked emerging sovereign debt strategies follow an index – often structured in a way that is very (or too) exposed to the most indebted economies –, a strategy independent of any index enables differentiation, which has become necessary within the world of debt and emerging currencies.
By favouring a risk/return ratio in a given framework of volatility or of value at risk, this approach minimises the drawdowns suffered by the asset class and could help take advantage of any brutal shocks, in particular with respect to emerging currencies. This strategy is implemented first through a detailed analysis of the general macro-economic environment, which makes it possible to determine signs of global risk in the portfolio, to achieve a level of conviction concerning the market trend in the medium term, and to identify the themes (actions by central banks, commodities, etc.) dominating the market. At the same time, a detailed study of the various emerging countries through several prisms (economic, political and geopolitical), combined with a technical analysis of all the investment vehicles (sovereign debt denominated in hard and local currencies, corporate debt, forex) highlights the opportunities to be seized by the asset manager. The flexible nature of a total return fund makes it possible to back these opportunities through three major types of strategies combined efficiently: so-called “carry trade” strategies, long or short “directional” strategies and “relative value” strategies.
Carry trade strategies can be applied to “frontier” emerging markets, such as sovereign debt denominated in hard African currencies when the manager considers the default risk to be very low and when the risk premium is high considering the economic fundamentals. Considering the current environment, emerging currencies, such as the Brazilian real and the Russian rouble, are also good vehicles for carry trading, insofar as they have high real interest rates.
When the market’s valuation no longer matches the fundamentals, as is the case for USD-denominated Turkish debt today, a “directional” strategy allows this discrepancy to be captured for the fund’s benefit.
Lastly, relative value strategies implemented at a lower cost by financing the purchase of an undervalued asset through the sale of an asset considered “too expensive” can be “intra-country” or “inter-country”. In the world of emerging debt, the former case could concern, for example, purchasing the debt of a company owned mainly by a government and which has a historically high risk premium compared with the actual sovereign debt, whereas the underlying risk is not fundamentally different. When a yield curve exists in hard or local currencies, an arbitrage between short and longer maturities is also possible. “Inter-country” strategies in particular can focus on differences in the economic dynamic between two companies that are not reflected in market valuations.
Ultimately, a total return fund appears to be the most suitable vehicle to benefit from the growing heterogeneity of emerging markets, as well as the variety of available instruments, while monitoring the risk taken by investors.
From Marine Marciano Rimeu, EM Fund Manager at La Française