Q. What is the underlying methodology behind the managing of the fund?
We are an active benchmark manager with a complementary top-down and bottom‐up approach. We believe:
• A top‐down view of the macro environment enables us to assess how attractive conditions are for taking risk
• Understanding the direction of a country’s credit quality enables us to establish a bias
• In local currency debt markets, currency and interest rates are distinct sources of alpha, which should be managed separately
• Success is improved by timing and disciplined management of stop and profit levels
Q. What have been the most profitable areas of the fund during 2013?
The strategy outperformed noticeably during Q2 2013, benefiting from very active portfolio decisions, in particular the significant underweight to emerging currencies, which contributed strongly in May and June. Our underweights that contributed positively to performance over the period included:
• The Russian rouble; one of the worst-hit currencies
• The Mexican peso; very much the darling of the market in the spring, which saw heavy position unwinding
• The Chilean peso; we had long believed it was overvalued, partly as a result of the weakness in copper exports
• Turkish lira; as political demonstrations in the country impacted investor sentiment
• Indonesian rupiah; one of the worst performers in the market
• South African rand; which came under heavy selling pressure
Q. Which emerging countries are best placed to become developed markets within the next decade?
It is important to look at a country’s institutional capacity to make this transition – this is a very important aspect of their progress. On the whole, when one looks at the institutional framework in emerging markets and what is lacking, then we have to conclude that emerging markets continue to be just that – emerging.
A lot of investors may have bought into the notion of this major convergence occurring between developed and developing economies but in actual fact, there are still many gaps that require investors to demand a risk premium on emerging market assets. There are of course many countries that are making good progress on this front – we are positive on Mexico, on Poland, on South Korea and on Peru, which recently had its credit rating upgraded, making it among the best rated Latin American sovereign credits.
Q. How do you view investment opportunities from both a currency and bond perspective?
A key thing to note is that economic cycles are not synchronised in the emerging world – Mexico and Russia can be expected to keep cutting interest rates while Turkey may well be hiking rates, so there are many different trends to consider. Investors need to differentiate between markets.
When it comes to currency positioning, things are a little trickier. There has been a notable deterioration in many countries’ external accounts – not to crisis levels, but a deterioration nonetheless. Some currencies may have a bit further to fall as a result. That said, we have seen a sharp selloff in emerging market currencies in recent months and some of those are starting to look attractive.
Q. What will be the main challenges facing the fund over the next year or two?
One question that we keep hearing is ‘Are we on the cusp of another emerging market crisis?’ Well, we think the answer to that question is ‘No’. True, we have had large moves in some emerging market currencies – units such as the Brazilian real, the Indonesian rupiah and the Indian rupee have seen significant falls since May.
But when you look at how currencies behaved in past periods of turbulence, you see far bigger moves. In the Asian crisis of 1997, for example, we saw the US dollar gain some 500 per cent against the Indonesian rupiah. So when we put this recent market volatility in historical perspective – and when we consider metrics that testify to a borrower’s willingness and ability to meet its debts, such as debt-to-GDP levels or foreign exchange coverage ratios – it is clear that we are not facing another crisis.
That’s not to say there aren’t vulnerabilities – some countries’ current account positions are deteriorating and others face tighter conditions in foreign capital markets. And investors are worried about this.
As a result, we have seen large investment outflows from emerging market debt. From 2010 to the first quarter of 2013, the market saw some USD 400 billon of investment inflows. That was referred to as a ‘wall of money’. Now, it seems, this has morphed into a ‘wall of worry’. Since the beginning of June, around USD25 billion has flowed out of the asset class. And given this has occurred at a time when market liquidity is poor, it has had a major effect on investment returns.
Some of this outflow may be down to tactical trades but I would say it is very difficult to treat emerging market bonds as tactical investments. The transaction costs associated with emerging market bonds are such that it makes it very expensive to trade in and out. We estimate transaction costs are around 40 basis points. So if your aim is to be tactical, you already lose a significant amount simply through transaction costs. You have to have a lot of confidence in your ability to time the market.
But looking ahead, I think one of the biggest trends to emerge from the withdrawal of monetary stimulus will be greater scrutiny of – and greater discrimination among – emerging market countries. For example, Mexico stands out as a country that is implementing significant structural reform in the areas of education, energy and telecoms and we think these measures will take the country’s long-term economic growth rate to a higher level.
On the other hand, there are many countries that are not doing what Mexico is doing and will probably become a focus for investor concern. For Indonesia, there are growing concerns about current account deficit levels; the same applies to Turkey, to South Africa, Brazil and India – these are the ‘fragile five’.
This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. Pictet Asset Management Limited has expressed its own views and these may change. The data contained in this document has been sourced by Pictet Asset Management Limited and should be independently verified before further publication or use. Neither this nor any other statement (oral or otherwise) made at any time in connection herewith constitutes an offer to sell or exchange units in the fund or any other fund or product and is not soliciting an offer to buy or exchange and does not constitute an invitation to subscribe for, buy or exchange any units in the Fund or any other fund or product in any jurisdiction where the offer, sale or exchange is not permitted. Potential investors are advised to obtain and review independent professional advice and draw their own conclusions regarding the economic benefits and risks of investment in the fund as well as the legal, regulatory, tax and accounting aspects in relation to their particular circumstances.