Panic has enveloped emerging markets as investors have lost faith in the growth story. Emerging market fundamentals have deteriorated across the board. Growth has slowed while debt levels have increased rapidly. This toxic combination has left investors nursing large losses and has forced them to question the rationale for emerging market investments.
Emerging markets have the potential to be an attractive investment destination. They have the potential to grow much faster than first world countries as they start at a much lower base of development. However, this potential growth has to be converted into actual growth through intelligent stewardship of the economy. In recent years emerging market countries, including South Africa, have failed to produce an economic and political environment conducive to growth.
Globally, there continues to be large amounts of capital chasing opportunities for growth, especially since growth and returns in developed markets is quite muted. If emerging markets can rebalance their economies and deliver structural reforms which are positive for growth, then they will continue to attract the massive investment flows which have been the norm for the last two decades. However, investors have been badly burned in recent years and the capitulation will intensify if the mismanagement of emerging market economies continues.
The following chart shows the growth performance of a range of emerging markets versus the 10-year average. Growth rates have slowed across the emerging market universe and with it the relative attractiveness of emerging market investments. South Africa, Brazil, Russia and Turkey stand out as countries suffering a severe slowdown relative to recent history.
Fears of an interest rate hiking cycle in the United States precipitated a massive outflow from emerging markets in the third quarter of 2015. Investors withdrew $40 billion for the three-month period with $21 billion from debt markets and $19bn from equities. This high level of withdrawals has not been seen since the financial crisis in 2008. The International Institute of Finance recently reported that net capital flows to emerging markets in 2015 will be negative for the first time since 1988. This is a dramatic reversal of a long-term trend and it is not surprising that emerging market currencies came under severe pressure. The following chart shows the performance of the rand and the JP Morgan Emerging Market Currency Index. For the last five years investors have suffered consistent losses on their emerging market currency positions. This has been a severe detractor to investor returns as the gains in equities and bonds have generally not been sufficient to offset the currency depreciation.
Bond yields have also risen as global investors have not been willing to chase yields pickup aggressively as they continue to lose capital through currency depreciation. Emerging market bond yields relative to DM has risen towards the panic levels of the financial crisis of 2008. If investors continued to experience capital loss on the currency movements, then their required yield to hold emerging market currencies will continue to increase.
While emerging market fundamentals remain poor, the negative sentiment has at times become extreme. However, these market moves have the potential to create opportunities. In the Nedgroup Investments Flexible Income Fund we have utilised the negative patches of emerging market sentiment to add performance to the fund in a number of ways:
We have added exposure to South Africa Credit, as well as corporates such as Naspers, Old Mutual, Impala, FirstRand, Eskom and Transnet. By investing in offshore bonds we have achieved yield pickups twice as large as what the domestic market offers. We have limited risk by investing in shorter term bonds with a weighted average term of 2,5 years. The ability to actively manage offshore bond exposure has enabled us to add significant value to the fund through yield pickup and capital gains.
The deterioration in the growth outlook for emerging markets has disappointed investors. Key markets like Brazil, Russia, Turkey and South Africa have experienced a significant deterioration in political and economic fundamentals. However, periods of extreme negative sentiment have created opportunities to add value at low risk. We will continue to manage the Nedgroup Investment Flexible Income Fund cautiously in this environment and take advantage of opportunities to add value as it appears
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