Investors should steer clear of emerging markets despite their recent surge in popularity, according to James Harries. 
The star manager, who recently joined Troy Asset Management after running Newton’s Global Income fund for more than a decade, says that the market area is at the end of a credit boom which is now in the process of unravelling.
While he is cautious towards emerging markets at the moment however, he says it is likely to begin yielding opportunities in the medium term and is currently researching companies in the sector.
“I have a relatively strong view on emerging markets and it isn’t good, in the sense that the recent history has been characterised by a grand reach for yield,” he said.
“As an income manager, one has to be very cognisant of that because whenever everyone else is reaching for yield is the time when you shouldn’t be.”
Since the start of the year, the MSCI Emerging Markets index has returned 23.55 per cent compared to the FTSE 100’s return of 9.1 per cent and the MSCI AC World’s index’s return of 16.18 per cent.
Performance of indices in 2016
Source: FE Analytics
Given the shock Brexit results and the impending general election in the US as well as other geopolitical headwinds on the horizon, many investors have flocked to emerging markets for safety -this is despite the developing world’s poor performance over the last five years.
Just last week, BlackRock Investment Institute’s report highlighted its growing conviction in the market area given that it sees less risk of a sharp rise in the US dollar and that currencies have adjusted.
“In equities, we like India on improving economic and reform momentum, and Southeast Asian countries with domestically led growth,” it said.
Harries says that during strong periods for emerging markets, countries tend to suppress their exchange rate in order to maintain competitiveness, which in turn imports loose monetary policy and foreign capital.
While a credit boom is therefore created in favourable conditions, according to the manager, he says that the opposite rings true for when emerging market economies are faring less well as capital leaves the economies relatively quickly.
As such, he says the regions tend to hike their interest rates to protect currency and have to tighten monetary policy at the wrong time in the cycle.
“Monetary policy tends to be very cyclical in emerging markets in a way they shouldn’t be. That is where I think we are in emerging markets, we are at the tail end of a credit boom and I think that is in the process of unravelling,” the manager warned.
“What is different this time is that in the old days, and by that I mean every time up until now, there would tend to be direct either investment or bank lending into these economies. When there was a problem, they’d be able to work it out over a number of years.”
“This time people are just going to sell because they can, because they’re in daily-dealing mutual funds and I suspect that is going to lead to a material repricing of credit risk in emerging markets over quite a short period.”
“I think there’s trouble coming. What we’ve seen is a counter-trend move but I think that ultimately, the dynamics of the credit cycle combined with falling returns on capital as a result of overcapacity and as a result of monetary policy, is what the fundamental problem is.”
Harries explains that one of the reasons emerging markets have moved in a more positive direction is that data from China has improved, which has in turn benefitted emerging market currencies, commodities and credit spreads.
Performance of indices in 2016
Source: FE Analytics
However, he says that the country is troubled and that the bigger picture remains negative there, which is another reason he remains sceptical towards emerging market equities.
“The big question that is unanswered there I think, without focusing on one specific area, is to what degree these moves will impact Chinese creditors,” he continued.
“Why I say that is because we know there’s been this almighty credit boom in China, we think there’s likely to have been an extremely large misallocation of capital as evidenced by empty cities and all the rest of it. What we don’t quite know is how that’s going to play out.”
The manager points out that there are two paths that Chinese creditors could take and this will impact the speed at which emerging markets start to fall again.
The first scenario he gives is that Chinese creditors behave like Japanese creditors in that they’re willing to evergreen outstanding loans and will allow the process of repayment to be drawn out over a longer period of time.
The second scenario, according to Harries, is that Chinese behave like the more stringent US creditors and this will therefore accelerate a sell-off in emerging markets.
“I think it depends largely on whether the Chinese have control of their shadow banking system and I don’t think anybody has the answer to that, including the Chinese themselves,” he said.
“Now, longer term that will create a fantastic opportunity, because if you can be a provider of liquidity when others are forced sellers, you can pick up some fantastic assets in cheap currencies, in competitive economies, which after all have lots of favourable long-term characteristics such as better demographics, functioning banking systems and upward sloping yield curves – all the things an emerging market manager would tell you about.”
“There are no plans as of yet but that’s where we’re looking for ideas now, so we can begin doing the work on the sorts of businesses we’ll eventually want to invest in.”
Troy is due to launch its global equity income fund later this year, which will be followed up by FE Trustnet.
Over Harries’ decade-long tenure of the four crown-rated Newton Global Income fund, it returned 135.05 per cent and outperformed its sector average and benchmark by 57.75 and 36.36 percentage points respectively.
Performance of fund vs sector and benchmark under Harries
Source: FE Analytics
