After largely being ignored for some time, the last six months have marked a tremendous return for emerging markets. In July alone, emerging market bond funds attracted approximately $9.43bn in inflows as European equities continued to struggle after the Brexit vote.
Indeed, many have marvelled at the resiliency and stability emerging markets have exhibited in recent months particularly as developed markets struggle.
But Greenberg, manager of the Hermes Global Emerging Markets fund, said investors who have blindly followed the trend in a bid to find yield may soon be disappointed.
“People jumped into emerging markets for the wrong reasons,” he said. “It’s the old carry trade weak dollar pickups of yield in a yield starved world. And as that happens, the cost of capital in the local economy goes down, but what kind of a fundamental is that? Then all of a sudden when the dollar goes up again, yields go up, currency goes down and you have got nothing.”
And Greenberg argued we reached the tip of the turning point last Friday when Fed Chair Janet Yellen strongly hinted that a rate hike was in the cards for the second half of the year.
“Yellen and Fed Vice Chairman Stanley Fischer have made it clear that there is at least a 50% chance of rates being raised. Therefore, carry trade is no longer a one-way bet and in fact is going to become increasingly risky. The real question is when are earnings in emerging markets going to recover? And are we also going to see a global macro recovery?
“Typically, slow growth isn’t good for emerging markets,” he noted. “You need acceleration in the developed markets. We have had our dessert before the main meal in the form of interest rates coming down because of the portfolio flows for yield.”
Emerging markets investors will have to wait a bit longer for the main meal, a pickup in economic growth and consumer spending, until US rates are able to normalise, he argued.
“If it is possible for the Fed to get rates up to 3-4% over the next several years, then the Fed will be in a position to allow the economy to go into a recession and we can have a normal economic cycle. In anticipation of that, I think emerging markets can start to perform better.”
He added: “The US dollar would rise along with the prospect of rate rises and as we get toward the peak of that, maybe sometime next year emerging markets would start to discount an easing cycle. And at the same time that was happening, emerging economies would come out of their slow down with the exception of China.”
In anticipation of this, Greenberg has maintained his overweight position toward Asia Pacific equities, currently 71.32% of his portfolio.
“Countries with robust internal positions with high levels of foreign exchange reserves, such as China, Taiwan, South Korea, and to some extent, India will be able to withstand the rising US rates the best. Whereas countries with external vulnerability like Turkey, Brazil and possibly Mexico and South Africa will be the ones that are under the cloud.”
And Greenberg added, materials and energy would be the most negatively affected sectors in this scenario. “I don’t think they will be that strongly negatively impacted because they already went through a bear market recently, but they will not benefit from a stronger dollar.”
Despite some potential drawbacks during the emerging markets “digestion process,” this would lead to a better earnings prospect for rates and a healthy emerging markets bull market unlike the current bull run, Greenberg concluded.
