A stronger dollar and rising US short rates are adding further pressure to emerging market economies, according to Brooks Macdonald’s Jonathan Gumpel and Niall O'Connor.
Gumpel and O’Connor, who oversee the five FE Crown-rated Brooks Macdonald Defensive Capital fund, said investors should be cautious on emerging market equity and debt as both asset classes remain vulnerable in the current environment.
“Stronger dollar and rising US short rates are adding further pressure to emerging markets’ economies, in particular,” said lead manager Gumpel.
“Also, we have already seen some countries -including Turkey, Argentina and Brazil- having to support their currencies, which will have knock-on effects.”
Given the current environment where emerging market valuations remain high and spreads are “excessively tight” the pair said they remain cautious and have not added direct exposure to the area.
“We believe we will eventually still see lower unemployment leading to higher inflation, which would be negative for bonds and equities,” Gumpel added.
Elsewhere, the pair noted they see a “very interesting” divergence between what is going on in Europe and what is going on in the US, with some disappointing eurozone and global PMI [Purchasing Managers’ Index] figures but strong US PMIs.
Indeed, latest PMI data showed the rate of expansion in the eurozone economic activity eased to a one-and-a-half year low in May, suggesting a less bright outlook for the economy than in the opening quarter of 2018.
Eurozone composite PMI since 1999
Source: IHS Markit
“In Europe clearly when you look at the PMIs, which is a good lead indicator of the strength in the economy, they are still high,” said deputy manager O’Connor. “But they have definitely shown some signs of weakening.”
O’Connor said that as a result of slower growth the European Central Bank (ECB) has been loathe to rush the normalisation of policy and raise rates quicker as the Federal Reserve has in the US.
“That will inevitably push down bond yields and push down the euro but also should be supportive for the eurozone assets, like eurozone equities,” he explained.
“However, US PMIs are still strong, which means further divergence in US and Europe that could lead to a strengthening dollar and support US equities.”
Given PMI figures remain very high and employment is at an all-time low in the US economy, O’Connor noted there are early signs of inflationary pressure there, with the quantitative tightening that is expected to come from the Fed definitely under way.
The team believes Q3 and Q4 are going to be tough quarters and expect 10-year US Treasury bills to continue above 3 per cent towards the end of 2018 – although that will also depend on how US president Donald Trump’s political decisions influence the performance of the asset class.
Source: St Louis Federal Reserve
O’Connor added that while all of this is very positive for a strong dollar, Asian markets aren’t the same as they were in 1998, where there was a very large amount of US dollar-denominated debt, the team sees emerging market economies with decent size of current account deficits.
“We also see some US dollar-denominated debt like Argentina that was struggling recently, Turkey that has also been having problems, Brazil… But having a current account deficit basically you are being funded by foreigners,” he explained.
“When risk-free assets are yielding more in your domestic environment, inevitably people will start bringing money back home as we have seen with the introduction of tax rules by Trump, where we have seen a re-domestication of US dollars.”
This, O’Connor noted, makes it harder for emerging markets, where there has been a lot of money flowing into debt given the high spread.
Noting some indirect exposure in the Brooks Macdonald Defensive Capital fund, O’Connor warned: “I think people have maybe forgotten these assets are a little bit riskier than they thought of before.”
“Now we are looking around to see if we can find what we think are under-priced assets because there are still assets out there that we think are fully priced to our mind, anything AAA looks expensive but there are some assets which look cheap,” he added.
Recent changes to the £551.7m fund include an increase of their position in listed hedge fund BH Macro. However, Gumpel and O’Connor said they remain cautious over the longer term, as they still see valuations as high and spreads excessively tight.
Performance of fund over 5yrs
Source: FE Analytics
Over five years, Brooks Macdonald Defensive Capital has delivered a 26.74 per cent total return compared with a 13.01 per cent gain for the average fund in the IA Targeted Absolute Return sector. Although it should be noted that the sector is home to a range of strategies focusing on different assets and geographies.
The fund has an ongoing charges figure (OCF) of 0.82 per cent.