Taking dedicated exposure to Asia rather than a broader emerging markets position might be the best option for investors worried about the impact of strengthening dollar, according to several fund managers.
So far this year, the MSCI AC Asia index (up 1.42 per cent) has held up better in sterling terms than the MSCI Emerging Markets index (down 2.28 per cent).
Much of the volatility has been in the period since April, when the US dollar moved materially higher versus other currencies, and this could be detrimental for emerging market investors, according to Schroders fund manager Richard Sennitt.
Indeed, while in 2017 there was a tailwind for emerging markets in general from a weaker dollar, this has obviously started to reverse and that has had a big impact on currencies around the world and particularly those of emerging markets.
Below, the chart shows the impact this move has had on Asian currencies and those of emerging markets outside of Asia.
Currencies in the Europe, the Middle East & Africa (EMEA) as well as those in Latin America have been hit the hardest by a strengthening dollar.
Performance of currencies vs the dollar since 17 April 2018
Source: Schroders
“That is because a lot of these countries outside of Asia are still running quite large current account deficits and also have quite a lot of external debt financed in dollars,” the manager of the £1.3bn Schroder Asian Income fund said.
“When you are running a current account deficit you are effectively short the dollar so as rates go up obviously it induces quite a tightening.”
A lot of countries still harbour the scars of the Asian financial crisis in the late 1990s, when most were running deficits, he explained.
Now, however, most of them are running surpluses, with the exception of India and Indonesia. External debt levels of Asia as a whole are also much lower than those of other regions.
As the below chart shows, the Asia region has just 13 per cent of debt in US dollars, with 71 per cent in local currency.
Table of total debt in different currencies
Source: Schroders
This is slightly behind the levels in developed markets but much lower than those in the EMEA and Latin American regions.
Sennitt said: “The developed markets as you would expect are financed in local currencies and Asia is not too bad with over 70 per cent in local.
“Yes, there is US dollar debt but it is a bit of a surprise that there isn’t more offshore debt and I think that is partly the memory from the Asian crisis that is feeding through.”
He added: “If you look at EMEA and LatAm you can still see that the level of offshore debt is still very high meaning they are more vulnerable to tightening of the dollar.”
This implies that funds avoiding those regions and focusing instead on Asian equities might be in a better position, something that Jason Pidcock, manager of the Jupiter Asian Income fund, said may come to fruition in the coming months and years.
“I am not a currency forecaster but the trend is clear – [the dollar] has been going up – and when it does it tends to make life difficult for emerging markets generally because it sucks the liquidity out that has been going in when monetary policy is loose and the dollar is weaker,” he said.
“We are starting to see a reversal of trends which have been in place for much of the last 10 years. Monetary policy is not quite as loose as before and we are seeing some countries go from QE [quantitative easing] to QT [quantitative tightening] and interest rates in some places going up.
The manager added: “That is less of an issue in Asia but it is an issue in some emerging markets and that is why Turkey has been singled out as one of the more fragile countries because it has a lot of US dollar debt.”
He said the reason it is more of an issue for emerging markets than it is for Asian equities is that investors tend to react quickly to negative sentiment.
As such, there is a “domino effect”, whereby if one or two emerging markets begin to falter – as has been the case with the likes of Turkey, Argentina and Brazil – then investors start to look for other areas of weakness.
“People tend to look for the next weakest, and because foreign capital flows can swing things around it can be self-fulfilling,” he said.
“If you get a bit of money coming out of a country it can feed on itself because some of these countries are dependent on capital flows – especially if they have twin deficits [budget and current account].”
While this may be a benefit to a dedicated Asia fund when compared with an emerging markets fund, he noted that those emerging countries within Asia will not be spared entirely.
As such, he has reallocated much of his fund away from emerging market countries within Asia, instead focusing on those that are more developed.
“The beauty of Asia is that you get a real mix of countries – so some are very developed and some are more emerging. You can move around within the region and can choose to be invested in developed markets if you want to,” he said.
“I now for the first time in my career don’t have any exposure at all to Thailand, Indonesia, Philippines, India, Pakistan or Vietnam. Some of those markets I am rarely, if ever, in but it is unusual not to have a single stock in all six.”
Table of portfolio weighting by country
Source: Jupiter Asset Management
He moved his portfolio away from developing economies towards the end of last year as the US dollar was weakening, leaving only two emerging markets countries in the portfolio – Malaysia and China.
“I see Malaysia as being at less risk than some others and you can’t really avoid China but there are some very developed companies in China,” he said.