EM contains contagion risk

You can enable subtitles (captions) in the video player

Welcome to Hard Currency from the Financial Times, our weekly exploration of the foreign exchange market. I'm Roger Blitz. And with investors in a state of limbo this week over the dollar and the euro, it was Turkey's lira that grabbed attention with a dramatic fall over a diplomatic fallout with the United States.

Turkey's problems, frankly, look fairly well self-contained, but are the prospects for emerging markets' currencies in general, what are they like? The dollar's weakness all year has been a blessing for EM, but that was until September when a dollar revival had EM currencies running for cover. So is EM ever going to break the shackles of the dollar correlation, or is there some underlying reasons for optimism?

I'm joined this week by Sergei Strigo, who looks after EM debt and currency at the European asset manager Amundi. Sergei, how has EM been for Amundi this year?

EM has done actually very well for us, for Amundi and I think for the market in general. So pretty much across all asset classes in emerging markets-- whether it's US dollar bonds, hard currency, FX, or domestic bonds-- are in sort of high single-digit, mid teens. If you look at EM equity, the returns are even higher than that. So it is definitely a very good year for emerging markets in general, which obviously we can see in the significant inflows to the market.

Yes. And you put that down to the weakness in the dollar in the main?

It's a combination of factors. I think it's the, first of all, still very low global interest rates that are actually pushing investors to look for less conventional asset classes. And emerging markets is certainly one of them. This is what we call a search for yield. And that's really across the board in all the types of emerging market asset classes. Currencies are higher yielding than the dollar and the euro and majority of the other G10. Emerging market bonds in both local currencies and dollars are also higher yielding than some of the other comparable developed market bonds. So this is driving this push towards higher-yielding assets.

And on the other side, very importantly, we've had a significant turnaround in the macroeconomic situation. And this is very important because it's making investors very comfortable in investing in emerging markets. We've seen countries that were in the recession a couple of years ago, like Russia and Brazil, are coming out of those recessions. Inflation is very low across the board in emerging countries. Hence, central banks are still cutting interest rates, which is very positive for bonds.

OK. So when we get to September and the dollar starts going up and we get a bit of a wobble on emerging markets, what do we make of September therefore?

The September wobble was really mostly due to the US issues, I would say. So we've had obviously market recession somewhat. The likelihood of a December hike by the FOMC. So now we are around 80% the probability of a hike, which is significantly higher comparing to where we were in August. Some of the macroeconomic data from the US has been a little bit stronger, and there is renewed noise on the potential tax reform from the US administration. So all of these things should be supporting dollar.

So what goes up with the dollar will go down, which kind of makes the agnostic EM investor wonder whether that correlation is ever going to break. I mean, to the point you were making earlier, some of the fundamentals are improving, but you can't get away from that correlation or that inverse correlation with the dollar.

No. Short term, probably you wouldn't. But if you look at the medium to long term, ultimately investing in emerging market currencies you're still picking up significant yield comparing to dollar or euro or any other underlying developed market currencies. So over medium to long term, it still makes sense to invest in EM currencies. And on the valuation side, we've had the significant depreciation in the majority of currencies during the commodity price collapse in 2014. So arguably, also on the valuation side, emerging market currencies are actually quite cheap.

The other correlations people tend to look at with emerging markets is China, how China is doing, its economy. And also linked to that is how many commodities China is buying and therefore the commodity price. That's perhaps more related to commodity currencies within EM. Actually, we're coming out to the People's Party Congress next week with China, so this is also going to be an interesting, perhaps nervous time for EM.

It could be. I mean, China obviously something to be watched all the time in a sense. But what we've seen certainly this year-- and this is really a very similar trend to the other emerging market countries-- that Chinese growth has actually picked up. They've done fiscal stimulus, monetary policy stimulus, et cetera, and supporting the real estate in China.

So in general I think what we're looking at today is continued stability of Chinese economy. And this is really what people want. It's not necessarily that investors want to have an 8% growth or 9% growth in China. They want a stable growth which is easy to forecast. And this is actually what we're witnessing these days.

Would you say, therefore, that the correlation between EM is still going to be very strong with China than compared to the correlation with the dollar? Actually, that's the area that the investor has to look at more?

In a sense, yes, but I think the correlation will be higher if China goes significantly down in terms of economic growth. It's a downside risk which is really going to spook the market, which, as of today, we're not really seeing that happening.

With EM, we always worry about how it has a contagious effect. And perhaps looking at Turkey this week, we could safely say that there wasn't any knock-on effect elsewhere in EM or in the rest of the market. Is that right?

You're absolutely right, yes. And I think this is a sign of maturity of emerging markets, where investors are able to differentiate between different countries and the reasons why they perform in a certain way. And you're absolutely right, there was renewed political noise in Turkey, and that only affected Turkish assets.

We can look at other examples. For example, the corruption scandal in Brazil equally affected only recorrected in May. Renewed allegations of corruption only affected Brazilian assets, currencies, and bonds. Didn't really do anything even to the sort of near abroad in the sense of other countries in Latin America.

All this is pretty good for EM, actually. We're talking about correlations breaking down. We're talking about contagion no longer there. But for the rest of the year, for the rest of 2017, a possible Fed hike, a possible ECB tapering, what in the short term should the EM investor be thinking about?

I'm still positive for EM into the year end and over the next few months. I think, yes, notwithstanding the fact that the Fed is probably going to hike and as you said the ECB will probably start tightening in one way or the other, the yield and the carry offered by emerging assets is still significant. And couple that with the improvement in the fundamentals, it is a pretty interesting space to invest in today.

So it is becoming more and more a carry story rather than a significant, I would say, price appreciation story. Because, in terms of looking at the valuations, certainly the credit spreads are towards the tight end of the range. There is still room for them to compress clearly, but that trade is getting exhausted somewhat. On currencies, we can argue there is a bit more room to appreciate. But again, we have to look at what the euro-dollar is doing on the other side.

And on the local currency bonds, we're still going to have for the next few months interest rate cuts in a number of important emerging market countries. So from the domestic monetary policy side, local bonds certainly add value to that.

OK. So that's the end of this year. So what about 2018? Let's take, say, the first quarter-- if you're brave enough, the second quarter as well. What are the prospects more medium term?

Sure. On the first quarter 2018, I think we're probably going to see a continuation of the trend that we've seen today. There is significant inflows into the market, and this is what is driving short-term market moves in emerging market bonds. Going forward into sort of mid-next year and later, we have to look at what is ECB actually going to do with regards to potential tapering or monetary policy. And then we'll have to see what the Fed reaction function is going to be. Don't forget that we are also waiting for the next chairman of the Federal Reserve Committee, which is going to be an important indicator of what we can expect.

Yes indeed. OK, Sergei. So just finally, I'm going to ask you three things about your picks for within EM. Where should the investor avoid? Where in EM would you say, ooh, I'm not sure about that at all?

Look, if you look at the market today, looking at the macroeconomic situation in emerging market countries, in the developed countries-- which is broadly improving-- looking at the valuations, I prefer to be in the higher-yielding assets in general. And that is in currencies, in US dollar bonds, or in local currency bonds.

Some of the countries or regions that stand out as given better valuations are certainly Latin America-- for example, countries like Brazil, Argentina, Mexico. Also, on the corporate side, there are some interesting opportunities in investing in emerging market credit, corporate credit. Asia does look a little bit expensive to me. If you look at the absolute level and sort of, I would say, real rates in Asia, less of a value call there. Plus obviously the risk of China, which is, in a sense, always there. And obviously, some sort of US administration move against China with regards to protectionism.

Excellent.

That's the region where I'm a little bit more cautious today.

OK. So you've actually helped me answer two questions. I was going to ask you where to avoid and where you go. You've answered that. So the final question is, can you give our listeners a surprise part of EM, a part of EM that perhaps they wouldn't naturally have thought about or which is not really talked about a great deal, where you think actually that's got a lot of potential?

I think the frontier markets is certainly something to look at, and we're seeing more and more new countries coming and issuing bonds. For example, Tajikistan was the country that fairly recently issued their first ever emerging market bond. So this is something very interesting because the valuations in some of these places are quite interesting to look at.

And I think over the next year or so, I mean clearly I think what is going to be on the investors' radar is probably going to be Venezuela. The situation with Venezuela with the essential credit event or not, this is something which is going to be quite interesting to monitor.

All right. My thanks to Sergei Strigo of Amundi. Next week, it is the China Communist Party Congress. Expect an awful lot of chatter about the renminbi and China's growth outlook. So join us to discuss these and other issues on Hard Currency. Until next week, it's goodbye.