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Headlines or headache?

MIKE REYNAL 24-Oct-2018

Let’s not mince words. The emerging markets value proposition is being called into question by media pundits. The headlines scream about a trade war between the U.S. and China. A currency crisis has plagued Turkey and Argentina, conjuring up memories of prior contagions. And the talking heads love to cite how a strong dollar and higher U.S. interest rates pose potential challenges for emerging markets investors. 

Apparently, many are fixated on these headlines and are taking a wait-and-see approach to emerging market equities. But we think the recent sell-off in emerging markets may be played out. In fact, there are signs that investor sentiment might be turning. 

For clues, let’s look at U.S. interest rates, often considered a harbinger of performance for emerging markets. In theory, higher U.S. rates makes debt more expensive to EM borrower-nations, which can be negative for local currencies and fund flows. Recently, investors were closely watching the 3% threshold for 10-Year Treasuries. So much for that. When this “barrier” was broken in September, EM stocks barely moved, possibly indicating that the news had been discounted by the market.

Moreover, since the U.S. dollar peaked in mid-August, it has fallen versus a basket of EM currencies, even as Treasuries stayed comfortably above 3% (as of the writing of this post). We believe this weakening bias in the U.S. dollar is based on a variety of factors, none bigger than the correlation of the dollar to the federal budget deficit, which is now almost at 1:1 ratio. If weakness in the dollar persists, it may take pressure off the tariffs story and other negative headlines. In fact, it could be a catalyst for turning sentiment. Time for a rotation?

Still, we understand that the weekly and sometimes daily market machinations can be a headache for investors. In the near term, emerging markets investors must be prepared to navigate periodic negative news flow and subsequent bouts of turbulence. But we think investors should be ignoring the sensational headlines and focus on what matters most.

For Sophus Capital, what matters most is that the emerging markets value proposition seems intact. We continue to stay true to our process, finding attractive opportunities with the characteristics we seek—specifically, superior earnings growth at attractive valuations with revisions as the catalyst. Moreover, the transformation from export-dependent commodity-driven economies to more sustainable service-oriented economies continues to be supported by a rising middle class. While we always carefully monitor risks, we believe the secular trends in emerging markets are supportive of an optimistic long-term view.