Identifying Risks and Opportunities within Emerging Markets
The month of January saw renewed selling pressure in emerging markets, marked by the continuation of two macro trends that we identified during the past year.
First, China continues to struggle as a result of the deleveraging and slower growth that accompanies the successful rebalancing of an economy. Our November 2013 investor letter noted:
During a trip to Beijing in mid-November, we concluded that the People’s Bank of China is growing more comfortable with a tighter liquidity environment.
In our view, this is because:
- the pace of credit growth has been overly aggressive;
- the economy requires sustained deleveraging to achieve successful rebalancing in the medium term; and
- regulations targeted at limiting interbank (“shadow banking”) lending are encouraging banks to restrict short-term liquidity/interbank operations in favor of building reserves.
The third point is quite important in light of the fervor surrounding interbank/shadow lending. The tightening of interbank activity is now more aggressively transmitted into the ‘real economy’ as a result of the complex network of shadow transactions that rely on interbank activities.
Second, emerging market economies that are running fiscal and current account deficits are undergoing an adjustment, leading to currency depreciation and exerting downward pressure on domestic demand. Identification of this trend nearly a year ago led us to position the portfolio with these risks in mind. As we commented in our May 2013 investor letter:
Macroeconomic developments have begun to cause emerging market currencies to diverge. For non-local investment vehicles—such as U.S.-domiciled emerging markets mutual funds—such shifts represent a risk to net performance as increasing dispersions among currencies may hurt USD returns for associated equities.
Given our active management approach and our synthesis of micro and macro research, we have accordingly pared back on selective areas where fundamentals may be jeopardized by sustained currency pressures. Some examples of tactical adjustments include decreases to positions in small markets such as Thailand and Indonesia, as well as to some defensively positioned companies where multiples have rerated ahead of fundamentals as a result of the low-rate, low-volatility environment.
Where do we stand today? Economic rebalancing in China will likely unfold over time, and we expect that growth and the mix between consumption and investment will be managed by the authorities. The widely covered near-failure of a Chinese trust product highlights the ongoing financial stress and the need to rein in off-balance sheet activity. We maintain an underweight position in areas that could be affected by tighter credit conditions and lower growth, including the commodity-centric exporters to China.
While numerous EM central banks have raised interest rates or used FX reserves to defend their currencies, the market remains skeptical of such moves in Turkey and South Africa, where further economic adjustment may be required. In other countries such as India and Indonesia, there is early evidence that suggests the adjustment is further along in the process. The Driehaus emerging markets strategies maintain underweight positions in Turkey and South Africa, two markets that have continued to see their currencies weaken. We have added back selectively to Indonesia, where the currency has now reached levels not seen since the global financial crisis. The economic data point to signs that rebalancing is unfolding, and we are finding ideas that are 30% or more off of their highs in U.S. dollar terms.
Going forward, we expect that growth conditions within EM will be choppy, but that the policies and approaches to economic rebalancing will distinguish the macro fundamentals at the country level. In this environment, we will continue to be nimble and active, employing our philosophy to synthesize micro and macro developments as we position the portfolio.