Contagion contained

29 October 2018

Istanbul overhead

Emerging market fundamentals are stronger than ever and talk of contagion, particularly now, seems overdone.

Seeing the opportunity

It’s been a challenging few months for emerging markets, impacted by talk of trade wars and ongoing currency woes. Unsurprisingly though, as active fundamental managers we see the dislocation between (often overly) negative market reactions regarding emerging markets and the actual longterm drivers of growth in the asset class as a compelling opportunity.

Indeed, we believe the asset class still represents good value in terms of an international equity allocation. Return on equity is fairly synchronised with developed markets, as represented by the MSCI World index. Importantly though, price-to-book and price-to-equity values remain low relative to history and developed markets.

Gust or storm?

Turkey’s currency crisis in early August prompted an all-too familiar set of headlines. A predictable news flow that was eager to foretell that the crisis would deepen and inevitably spread across the entire asset class. As is usually the case, ‘contagion’ quickly became the must-use word for every emerging market commentator.

Turkish flag

This customary, knee-jerk reaction prophesising that emerging market turmoil will develop from an adverse situation in one of the many differentiated emerging market economies is, in our opinion, not only wrong, but a completely outdated view of the asset class.

Distinctive markets

In previous bouts of emerging market turbulence, investors have often been quick to ditch the asset class, making little distinction between individual regions, governments, economies or companies. It’s a response which continues to have a lingering legacy, even though compared with any other point in history, emerging market countries are more stable economically, more independent of each other and increasingly diversified.

Times have changed and economic vulnerability (leading to contagion) in emerging markets has significantly lessened. What’s more, investors are also gradually becoming more aware of the different drivers between individual markets.

No two situations are alike

For instance, during the recent currency weakness in emerging markets several varied factors have been at play. In Turkey, the crux of the recent problem has been a substantial pickup in inflation, as well as relatively high foreign-denominated debt and a current account deficit, with the backdrop of some unorthodox policy moves not helping matters either.

By contrast, in Argentina (which is not yet part of the MSCI Emerging Markets index), circumstances are very different. The government tried to implement an ambitious fiscal adjustment that depended on constructive global markets and increasing Foreign Direct Investment (FDI). Unfortunately, the FDI did not materialise and markets became much more nervous, coinciding with some policy mistakes. However, the situation has been stabilised by an IMF credit line and interest rates at 40%. of some unorthodox policy moves not helping matters either.

South Africa, meanwhile, has also experienced currency weakness, forcing the monetary authorities to raise rates. The greater issue there is politics – in particular, the coincidence of a weak economy coinciding with the reforming agenda of new president, Cyril Ramaphosa, as he looks to break the back of the existing corrupt power structures in the ruling ANC.

Fundamentals stronger than ever

We should not downplay the seriousness of the situations these countries face – recessions in Turkey and Argentina are all but guaranteed. However, the currencies in question have largely stabilised (albeit it at much lower levels) and it is noticeable that wider contagion across emerging markets has not materialised. In Mexico in fact, although not widely reported, the peso has actually strengthened against the US dollar.

Of course, the rising US dollar that we have witnessed recently does have implications for countries where US dollar-denominated debt is high, such as Turkey. Yet, for many emerging markets that dependence on external funding has dropped significantly. Domestic bond markets have developed and provide a greater source of financing for emerging market governments and companies. Sovereign balance sheets are consequently in far better order than they were even five years ago, with debt-to-GDP levels lower and debt increasingly denominated in local currency.

In short, emerging market fundamentals are stronger than ever and talk of contagion, particularly now, seems overdone.


Important information

This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’). It does not constitute investment advice.
Past performance is not a guide to future returns.
Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds.