The spectacular recent growth in emerging markets has resulted in some staggering fund performances for those invested in regions such Brazil, Russia, India and China (Brics). Morningstar’s figures show that £1,000 invested in Invesco Perpetual’s Latin American unit trust five years ago would be worth more than £6,000 by now – and all the best hedge-fund returns in 2007 were from strategies centred on the 20 or so countries in eastern Europe, Asia and South America that are tagged as “emerging”.
But it may well be too late to join the party. As Tina Vandersteel, a fixed-income portfolio manager with GMO, tells the FT, while emerging market equities have risen by an average 320% over the past five years, they are now roughly 20% more expensive than their long-term average, trading on average p/es of 17.
The long-term fundamentals look solid, but many, like Dan Looney of Towry Law Investment Management, warn of the potential for “severe volatility in the bad times” as the credit crunch takes its toll on the global economy.
However, this gloomier short-term outlook shouldn’t put investors off emerging markets altogether. Local equity markets are now expensive, but the currencies look very cheap indeed. As Vandersteel notes, major currencies such as the euro have risen by as much as 40% against the ailing US dollar since 2002, but the equivalent for the leading emerging markets is just 17%.
The trigger for a substantial currency realignment, which has already started for some countries – the rupee has risen by roughly 14% against the dollar since last April – will be a growing desire to contain runaway domestic inflation.
Inflation hits emerging markets
Price inflation (a killer for anyone on a low income) rears up when too much money chases too few local goods and services. Local currency supplies are surging as emerging-market central banks create more money to satisfy demand from international investors trying to buy into profitable emerging-market investments. One result, as international currencies such as the dollar are swapped for local ones, is growth in foreign exchange holdings, or “reserves”, which then need to be managed by the local central bank.
These can be invested in, say, US or UK government bonds – both to earn a return and to assist local exporters by keeping a lid on currency appreciation. A healthy level of foreign exchange reserves also reassures international investors that, should they want to sell up, the local central bank will have access to sufficient euros, dollars or sterling to pay them back – reducing the risk of a damaging “rush for the exit”.
Money laundering for central banks
But what happens to all the new local currency that paid for those reserves? Left on the loose, it can trigger inflation. Stopping that is where ghastly sounding but vital “sterilisation operations” come in. These are designed to keep surplus local currency busy. One possibility is to encourage private investment overseas (so that local investors sell local currency to buy international ones), another is allowing foreigners to borrow in the local market. However, most central banks choose instead to mop up “spare” currency by selling local currency bonds with attractive yields.
But there’s a catch – by cutting interest rates to stave off recession, Western central banks, such as the US Fed, also reduce the return earned by emerging governments on their foreign exchange reserves to below the rates they have to pay to attract capital to their local bonds. In other words, their income falls well short of their expenditure. This can also defeat the original objective as the yield gap increases, attracting yet more “hot” foreign capital into the emerging market economy.
Luckily, there are some solutions. One is to task “sovereign wealth funds” with seeking higher overseas returns than are available on Western government bonds – right now troubled US banks, such as Citigroup and Merrill Lynch, make willing customers.
Another solution is gradually to let the local currency appreciate, a route currently being taken by India and China. This tends to reduce inflation (a stronger currency means cheaper imports) and push up bond prices (lower inflation also means lower bond yields). So foreign investors buying into emerging market bonds could profit from a double-whammy of rising bond prices and a strengthening currency.
Emerging market currencies: what to buy now
This makes local currency bonds look like very attractive options right now – and fortunately there are now some funds available that give private investors a way in.
Cheapest of the bunch is the Powershares Emerging Markets Sovereign Debt Portfolio (AMEX:PCY), launched recently to track a Deutsche Bank index based on more than 20 emerging markets, including China, Colombia and Brazil. Although priced in US dollars, it has compensated by more than doubling in the past four years. Annual expenses come to 0.5%.
A pricier alternative is the five-star Morningstar-rated Ashmore Emerging Markets Debt Fund. The fund is now open, via a broker, to retail investors, subject to a minimum subscription of e5,000 with a third of the fund committed to Brazil and Russia, and substantial holdings in the Philippines, Turkey and Argentina.
Finally, Hargreaves Lansdowne like the forthcoming UK offering from Threadneedle, their Emerging Market Local Fund (0800-068 3000) to be run by experienced fund manager Richard House.