Mark Dow’s Emerging Market Play

April 11, 2016 And what needs to happen in the emerging markets for fundamentals to improve?

Dow: Primarily, three things need to fall into place before you get bullish about emerging markets.

First, we have to have some sense about where the U.S. is going with rates. We're starting to get that sense. We've had our first hike, and we know it's going to be very gradual, and probably very modest.

The Fed and everyone else keeps ratcheting down their future growth rates for the U.S., and we're realizing that we're not going back to the levels of growth that we enjoyed before the financial crisis. There're some structural factors that constitute head winds. So the rates are low, and they’re also low in all the other developed economies.

But we feel better about rates. It's safer to be long rates and it's safer to be long emerging markets. Before, we were worried about a rapid rise in rates, and historically, that does bad things to emerging markets.

The second thing is we need to know where the dollar ends up. The dollar's rise has to end, or we have to be confident it's not going to get really strong from here. We've seen a lot of that already.

People realize we've seen the radical move in the dollar, and from now on, even if the dollar were to go back up again, it's probably not going to go up with the same kind of violence it did over the past 18 months. And if it did, it wouldn't surprise as many people as it did back then.

The final thing we need in emerging markets is growth. People need to see a growth-differential to feel better about emerging markets. We know the case of Brazil, for example. People think the Brazilian boom was based on commodities. But anybody who looks at the numbers knows that before the big boom in Brazil, exports were 16% of GDP. A few years ago, exports were only 11% or 12% of GDP. Brazil wasn't driven by an export boom. We know what it was driven by. The democratization of credit?

Dow: Exactly. Everyone for the first time could go out and buy on credit, as much as they want. And this happened not only in Brazil, but in almost all of the emerging market countries.

The developed economies, all the banks in Europe and the U.S., they exported the financial techniques they’d been using at home. They said the first one to get to Brazil, to South Africa, to Turkey, to Korea, these are the guys who are going to make the money. And they arrived. And that pumped up the economy.

Because these economies started from a lower level of domestic debt, household debt, it's not as tragic. But it's going to slow down growth until they start paying off this debt and grow their way slowly out of it.

In the meantime, there's no growth, and it makes countries vulnerable to policy mistakes. We've seen some of that with Dilma [Rousseff] in Brazil, and we've seen that a little bit in Turkey. Ultimately, there are a lot of reasons to believe this isn't going to be an old-fashioned emerging market crisis. We have flexible exchange rates. We have more reserves. We have deeper financial institutions, domestically. So financial markets there are a lot deeper.

For now, basically, the growth component is not there, but the financial landscape is such that they'll probably muddle through and, over time, growth will start to emerge. Once these three factors are in place, U.S. investors should capture the upside through stocks, local bonds, currencies, all of the above?

Dow: I'm not excited about emerging market equities yet because of the lack of growth. But it’s time to get fairly aggressively long emerging market local sovereign debt.

If you're playing this at home and you believe we're at the beginning of a bottoming process, you don't want to buy equities now. You have to reconcile yourself to the notion that you might miss the bottom, but you really can't add here because we're probably going to be going up and down for a while.

There's no growth to turn the earnings around. The currency will make people feel better about stocks. And we've seen the rally in emerging markets such as the Bovespa [Brazilian stock market]. But there's probably no earnings power underneath that.

My guess is that this rally will fade a little bit, and we're going to have another swing toward pessimism at some point. It won’t be as deep as what we had in January. But we'll find better prices to buy things. And if you already have a position, hang on to it.

On the other hand, the great thing about local currency sovereign bonds is that they have a really nice yield. And if you think the currency has taken its biggest hit, it's going to be hard for the currency to depreciate more than the yield you're getting from those bonds. You could build a diversified basket of emerging market local currency sovereign bonds. That's the best vehicle at this point to play emerging markets.

But the time for being bearish is over. The backdrop is that we have a rolling global deleveraging process. The U.S. is ahead of everybody else. And now everybody else is catching up, emerging markets included. They're going to have to work their way out from under their domestic debt burdens. How linked is what’s going on in commodities markets to emerging markets? We often hear they go hand in hand.

Dow: It’s interesting that we’ve also had a bear market in commodities. But the link between the two is much more sentimental than fundamental, because the big countries like China, Turkey, India are commodity importers. The world I grew up in where emerging market economies were all commodity exporters doesn't exist anymore.

If you look at the iShares MSCI Emerging Markets (EEM | B-100), the top country exposures and about 55% of the portfolio are commodity importers.

But commodities and emerging markets are linked psychologically for a lot of people. And they're on the same end of the risk spectrums. They're both considered high-risk investments, so people don't go into them until they're really ready to take risk. There’s a correlation, but the causation isn't fundamentally sound.

The point I would make is that if you look at what's happening in commodities and emerging markets right now, those two are trying to find a bottom. And they do correlate, even though there's no fundamental linkage between the two.

Contact Cinthia Murphy at [email protected].

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