1. What is the underlying strategy of the fund?
The Templeton Global Macro group employs a bottom-up, research-driven investment process characterised by deep research of investment opportunities. The strategy is formulated by combining qualitative macroeconomic analysis with quantitative tools to determine the most attractive opportunities across duration, currency, and sovereign credit opportunities. The group applies an active management, benchmark-unconstrained style, pursuing absolute returns over a one to three-year timescale.
2. What is the rationale behind the large allocation to Mexican Bonds?
The Mexican peso is significantly undervalued in our opinion, trading at essentially its lowest level in the country’s history. The country is being priced liked it’s in the midst of a crisis, but it is not in a crisis; the underlying fundamentals are much stronger, by our assessment. Mexico is the largest auto exporter to the US, overtaking Japan, and is cyclically tied to the US labour market, which is at full employment. With the US having one of the oldest vehicle fleets and with US consumption remaining healthy and the US labour force remaining at full employment, we expect to see strong auto demand from the US for cars produced in Mexico. A lot of labour from Mexico comes to the US and those earnings are remitted back to the home country. These remittance flows are an important capital flow to the country and a strong supporter of consumption within Mexico.
Additionally, Mexico does not have large government debt (less than 50% of gross domestic product). The Mexican economy is not just reliant on oil and is in fact structurally very different from other oil exporters. The country has recently undertaken a liberalisation of the oil market, allowing foreign direct investment in the sector. We’ve seen some very successful auctions from large foreign investors that are investing for 20 to 30 years, which continues to provide strong capital flow to Mexico. By our assessment, Mexico’s economic growth, fiscal balances and current account remain fundamentally much stronger than market valuations currently reflect.
3. What opportunities lie in Emerging Debt space currently?
In recent months, we have seen some stabilisations in emerging markets after significant volatility earlier in the year and despite some setbacks during the market reactions to the Brexit referendum. However, we see further room for improvement as the recent recovery does not appear to be anywhere close to the full cycle of valuation strengthening, given how far valuations dropped during the volatility. We have continued to see a subset of emerging markets that we think have excellent value and better underlying fundamentals than markets have indicated, even with the recent improvements in valuations. Our focus remains on specific countries that have solid fundamentals but that have recently been priced as if they were in a crisis, such as Mexico, Malaysia, Indonesia and the Philippines. We also see value in specific distressed special situations that are in a crisis but that we see having a clear path for exiting that crisis over the medium term, such as Brazil. Additionally, a select number of credit exposures in emerging markets remain attractive on a risk-adjusted basis. We have selectively added to our strongest convictions during periods of volatility and believe that global market fundamentals will continue to emerge over the medium term.
Concerns for a systemic crisis across emerging markets at times during the first half of 2016 appeared exaggerated, in our opinion. While there are certainly some specific risks, there are also significant differences between individual countries across the asset class. Most commodity exporters and emerging markets with poor macroeconomic fundamentals remain vulnerable, however, several other countries have much stronger policy management and better underlying fundamentals. Investors need to selectively distinguish between individual economies, in our opinion, and avoid viewing the emerging-markets asset class as a single entity. Certainly, there are several emerging markets that we are avoiding such as Turkey, Russia and Venezuela, but we continue to see value in some of the other select markets where there are no major imbalances, yet the markets have distorted their valuations. We think the subsets of opportunities in emerging markets are smaller today than they were during the global financial crisis in 2008–2009, but we do not believe that investors should avoid the asset class altogether.
Over the last decade, several emerging-market countries have increased their external reserve cushions, brought their current accounts into surplus or close to balance, improved their fiscal accounts, and reduced US-dollar liabilities—for example, today, countries like Malaysia and Mexico rely primarily on domestic sources of financing. Thus, currency depreciations have not triggered solvency crises as in the past. In fact, depreciations have reduced vulnerabilities by boosting export competitiveness and supporting growth. Additionally, some countries have more external assets than liabilities, so currency depreciation actually lowers their debt-to-GDP ratio. In our assessment, several specific emerging-market currencies are fundamentally undervalued and are poised to appreciate over the medium to longer term.
4. Which market scenarios would see this fund perform strongly?
On the whole, we have continued to position our strategies for rising rates by maintaining low portfolio duration and aiming at a negative correlation with US Treasury returns. We have also continued to actively seek select duration exposures that can offer positive real yields without taking undue interest-rate risk, favouring countries that have solid underlying fundamentals and prudent fiscal, monetary and financial policies. When investing globally, investment opportunities may take time to materialise, which may require weathering short-term volatility as the longer-term investing theses develop.
In recent quarters, we have shifted out of markets that we were previously contrarian on (that were once distressed but have now recovered and become consensus) in order to re-allocate to positions that have fundamentally attractive valuations for the medium term ahead. We have also maintained our exposures in several of our strongest investment convictions and added to these positions when prices became cheaper during recent periods of heightened volatility, including during the market reactions to the Brexit results. We have remained encouraged by the vast set of fundamentally attractive valuations across the global bond and currency markets even as markets have distorted valuations in the near term. Currently, we favour currencies in countries where inflation is picking up and growth remains healthy, yet the local currency remains fundamentally undervalued. Additionally, we believe rate hikes from the Fed are needed given prevailing conditions and that a return to appropriate monetary policy in the US can catalyse markets towards a broad fundamental recovery. Looking ahead, we expect depreciations of the Euro and Yen against the US dollar, rising US Treasury yields and currency appreciation across a select subset of emerging markets.
5. What challenges do Emerging Debt assets currently face?
As mentioned above, while there are certainly some specific risks, there are also significant differences between individual countries across the asset class. Most commodity exporters and emerging markets with poor macroeconomic fundamentals remain vulnerable; however, several other countries have much stronger policy management and better underlying fundamentals. Investors need to selectively distinguish between individual economies, in our opinion, and avoid viewing the emerging-markets asset class as a single entity. Certainly, there are several emerging markets that we are avoiding such as Turkey, Russia and Venezuela, but we continue to see value in some of the other select markets where there are not major imbalances, yet the markets have distorted their valuations.