The new emerging markets?
20 Dec, 2022

The new emerging markets?

Kevin Cousins – Head of Research at PSG Asset Management

Over the recent past developed markets have followed aggressive policy choices more reminiscent of those of emerging markets (EMs) of 20 years ago. The combination of very loose monetary policy and high debt burdens was joined by massive fiscal stimulus and wide deficits in response to the Covid-19 pandemic. Given this, it is no surprise that economic and, more recently, market outcomes have become very volatile.

Against this backdrop, Head of Research at PSG Asset Management, Kevin Cousins, cautions investors against backward-looking risk measures, ‘long duration’ assets and ignoring EM opportunities.

“Traditionally investing in EMs required a strong stomach.” Notes Cousins. “While residents and investors in the likes of South Africa, Brazil and Turkey have learnt to weather currency, interest rate and equity market volatility, EMs’ economic track record is punctuated by regular financial crises. These upheavals include the Latin American financial crisis in the early 1980s, the fall of the Southeast Asian ‘Tigers’ in 1997/8 and the Russian financial crisis in 1998.”

The past decade as seen repeated crises in Argentina and the current crisis in energy-stressed Turkey, Pakistan and Sri Lanka. EMs have severely underperformed their developed market counterparts over this period.

“While the root cause of this has underperformance has been ascribed to messy politics and poor economic policies, in practice, very pro-cyclical foreign capital flows are also responsible for exacerbating price moves.’ The Russian invasion of Ukraine and growing concerns about the investability of China have also recently impacted sentiment,” Cousins explains.

Traditionally, if you were asked which countries are running large twin deficits (budget deficit and current account deficit), are behind the curve in monetary policy with negative real rates, and are battling to control inflation, you would typically say it must be an emerging market, like South Africa or Brazil. However you would be wrong.

“Over the past two years, South Africa and Brazil’s twin deficits have averaged 4.3% and 9.7% respectively. This compares to 12.5% for the UK and 15.4% for the US.” Cousins explains. “It is clear that since the Covid-19 pandemic, developed market policymakers have overcome their historic reluctance towards fiscal stimulus and will use it repeatedly in the future in response to any ‘crisis’ – take, for example, the huge spending programmes in Europe (EUR376 billion) and the UK (GBP130 billion) to alleviate the current spike in energy prices.”

Inflation rates are also currently higher in the UK, US and Germany than in SA and Brazil, a historically rare occurrence. The German consumer price index (CPI) just hit 10%, materially above the 1974 peak of 7.9%. The German producer price index (PPI) is over 45%, the highest level since 1948!

The reality is that developed market central banks are still behind the curve in their fight against inflation. This is highlighted by current real policy rates, still ranging from -5% to -10% in the US, UK and Germany. This has contributed to some dramatic declines in asset prices. While we all know the tech sector can suffer steep declines, developed market government bonds have historically been held as risk mitigators. To have US long-dated Treasuries, German Bunds and UK gilts all decline over 30% in less than a year is unprecedented.

“The Covid-19 pandemic appeared to mark some important cycle turning points, with the new environment characterised by sustained higher inflation and strong nominal growth. After a decade of underinvestment and neglect, the EMs and ‘old economy’ sectors such as energy and mining are likely beneficiaries of this new environment,” Cousins continues.

“Investors have to look at risk differently. Wild fluctuations in currencies and bond yields happen on a regular basis in EMs, and hardly come as a surprise. However currently EMs are out of favour, under-owned and cheap by any measure. That is not the case with many developed market assets.”

“The use of quantitative measures derived from historical price volatility as a proxy for risk is nearly universal in modern finance. These models typically have look-back periods of 8 to 10 years, in essence calibrating risk on the long period of secular stagnation post the Global Financial Crisis. The huge exposure to expensive long duration assets is often justified based on these models. We believe that true risk for investors comes from a permanent loss of capital and, on the other end of the spectrum, the inability to deliver target returns over the long term.”

“When viewed through that lens, expensive, over-owned long duration assets with rapidly deteriorating economic fundamentals are the epitome of risk, irrespective of their price volatility over the last decade. In contrast, cheap, under-owned old economy and EM assets, well suited to today’s economic fundamentals, are attractive holdings with low ‘true risk’, despite higher historic price volatility,” Cousins concludes.



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