Nervousness around Donald Trump’s proposed trade policies, a lack of valuation appeal and higher inflows from ‘crossover’ investors are the reasons why AXA IM’s Sailesh Lad is holding more cash than usual.
It has been a difficult time for emerging market debt investors, with the rise of Donald Trump leading to some $13bn in outflows from the US election to the end of 2016.
But since then, the region has seen net inflows of around $14bn – meaning there is now more money in the asset class, despite ongoing concerns about valuations and geopolitical risks.
The manager of the AXA World Funds Emerging Markets Short Duration Bonds said: “Everyone was surprised both with the Brexit vote and then Trump as well and I think emerging markets took the brunt of that pain.”
Performance of index over 1yr
Source: FE Analytics
As the above graph shows, the Bank of America Merrill Lynch Emerging Markets Non-Sovereign index fell sharply following the election result in November but has continued to rise since the start of 2017.
“There were two countries that everyone was concerned about – Mexico and China – and I think they are still the two countries that people are concerned with right now,” the manager said.
“Trump has delivered on a lot of things he promised but there is a lot of things that we were scared and afraid of that hasn’t come through but is still in the pipeline and could still happen – he’s just got bogged down with a few things right now.
“But there’s nothing to say that he won’t renegotiate NAFTA [North American Free Trade Ageement], he’s going to have issues with trade in China as well and these are all issues that the emerging markets are concerned about and they’re still yet to come.
“And I think what’s happened is people have got a little bit more comfortable with the asset class because people expected this to happen pretty much in the first month or so and it hasn’t happened right now but for me those risks are still there.
“So I am a little cautious and wary that while our asset class still looks attractive to some extent because we have a lot of money coming in, the technicals are very strong, the supply-demand dynamic is very positive, the macro picture is improving and there is no real risk of inflation that there are in the developed world as interest rates are going to stay neutral. 
“The tailwinds are there to be very positive but the risks are still around and are probably just being kicked down the road.”
As well as this, the money coming into the asset class concerns the manager, who says it is part of a classic hunt for yield, with managers and investors from other areas buying emerging market debt to improve their overall pay-out.
“I think people have been a little cautious but because the money has flowed back into the asset class all dedicated emerging market investors who have increased their size have to some extent been forced buyers,” he said.
“People are now looking at the emerging markets whether its equities or debt and I think that this is the classic hunt for yield where crossover money from people who originally bought investment grade or high yield and stayed within their own universe are now looking further afield to get that incremental yield that they can’t get in their own asset class.”
The manager says while he is taking risk-off due to valuation concerns, crossover investors are buying but are far less likely to remain when there is a wobble in the market.
“For me personally I am uncomfortable with the valuation side of things and having a high conviction in the market right now,” Lad said.
“Whereas your crossover person might be looking at their asset class and saying ‘I can’t get 3 per cent in my own asset class so I will split out into the emerging markets where I can get 3, 4, 5 per cent for the same credit rating’.
“The problem though is at the moment there is a slight bit of panic these guys leave. And this is also the issue with ETFs which are relatively new in emerging markets but we’ve seen when there has been a little bit of nervousness they can influence the market.”
Indeed, Lad says that the spreads in the emerging markets are at the tightest levels seen in three to five years.
While on a hard currency basis (those in US dollar terms) valuations look overpriced as the dollar continues to strengthen, local currency markets also pose problems.
“In valuation terms hard currency debt on corporates don’t look that attractive whereas on the local side it hasn’t followed the same pattern and we haven’t seen the same rally in local market rates that we’ve seen in local currency.
“So right now I would say if I were an asset allocator within emerging markets I would increase my allocation to local markets and reduce sovereign on the back of that.
“But there are two elements to local markets and there is an FX element as well so as much as I would say local rates look attractive, local FX is still something I would question and be a bit more neutral on.
“You are still in an environment of a strong dollar and obviously when you are buying local market debt ideally you would like to take currency exposure as well but the problem with that is you may not have a strong opinion on where the FX is going. So you have a bond view and you have an FX view.”
As such, the manager is holding onto cash in his funds, giving him the potential to add to positions he believes will become attractive once a market wobble takes place and much of the new money leaves.
“I think depending on what the reason behind it [a market wobble] was I think people would be buyers. We’ve got quite high cash balances, we’re all seeing inflows, we would actually then say that there is more value in this market so let’s buy it,” the manager said.
“The flagship fund I manage is the Emerging Market Short Duration fund and that has close to 8 per cent cash which is relatively high.
“I normally keep cash around the 5 per cent level because I like to be involved in primary issuance because this is a more buy-to-maturity portfolio rather than dipping in and out. But the main reason my cash weighting is high is [because of ] valuations.”
The $1.2bn AXA World Funds Emerging Markets Short Duration Bonds has been the best performer in its sector since its launch in September 2012, returning 16.76 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
The four crown-rated fund focuses on US-denominated emerging market short duration debt, typically with a length of under three years.
The portfolio is underweight Asia and overweight South America and Europe and in a follow-up article next week FE Trustnet will look at the three areas to buy and the three to avoid in the emerging market space.