Raoul Luttik manages the NB Emerging Market Debt Local Currency Fund. The fund suffered an 11% drawdown in the last three months, compared to the 9.6% loss of its benchmark, the JP Morgan GBI-EM Global Diversified Composite Index.
The asset class has been hit by the tightening of liquidity by central banks as well as an increase in trade tensions between the US and China and tariffs the US has imposed on the Eurozone and Canada, Luttik told FSA on a recent visit in Hong Kong.
Luttik attributes the underperformance of his fund to “an overweight bias on foreign exchange and interest rates, and exposure to Argentina and Turkey”.
The two countries faced strong headwinds in the past few months. Turkey in particular has suffered from current account imbalances and out-of-control inflation, Luttik noted. The country’s central bank only belatedly increased interest rates more aggressively.
Argentina, on the other hand, was forced to drastically increase interest rates and saw its currency sell off. Earlier this month, the country arranged for a $50bn loan from the IMF to shore up its finances.
Getting to neutral
To mitigate further losses, the NB fund’s positioning has been moved closer to neutral with respect to the benchmark.
“At the start of the year, we were overweight in emerging market duration, but we have been increasingly reducing our exposure toward neutral positioning versus the benchmark,” Luttik said.
“We have been taking out a lot of directional risk in forex. Our current FX positioning is more or less neutral,” he added.
Even for more vulnerable currencies like the Turkish lira and the Brazilian real, the fund maintains a neutral weighting as opposed to zero. “We would not expect the pressures [on the countries’ economies] to change soon, but we also have already seen quite strong FX adjustments and we are more comfortable in staying close to home.”
Despite the sell-off, Luttik believes emerging markets are better positioned to weather interest rate increases than they were at the time of the “taper tantrum” of 2013. “The fundamental backdrop for emerging markets is at the moment stronger than it was in 2013,” he said.
“Growth is looking more healthy in a lot of countries,” he said, adding that inflation is not a problem and most countries have been managing their current accounts quite well. “There’s no excess growth that results in current account imbalances.”
Risks
Risks, however, remain. “Emerging markets are still quite reliant on global trade,” Luttik said. “It is an important driver of returns.”
Moreover, countries like Argentina and Turkey will remain vulnerable for some time, affecting the perception of emerging markets as a whole, even though many other countries in Asia or Central Europe are doing much better.
The volatility may increase after a recent pick-up in outflows from emerging market bonds, which had strong inflows throughout 2016 and 2017. “If the outflows continue, this will create down pressure on the asset class.”
The current situation also may create liquidity issues, making it difficult to trade out of a position, he noted. This is exacerbated by “consensus positioning”, or herd mentality of emerging market investors. In some cases, in the weakest countries, in case of fixed income outflows, there’s no bid against which to sell.
In the longer term, Luttik is an optimist. “We still see strong emerging market growth, supported by strong fundamentals and valuations, and that’s something that should be picked up by the markets in the medium term,” he said.
Note: Returns in US dollars
