KBND - Emerging Market Insights: Headwinds For EMs From Higher Bond Yields

2023-03-08 01:26:00 ET

Summary

• Higher US bond yields and interest-rate expectations have a negative impact on long duration assets, including technology companies.
• Selected companies in India and Hong Kong which are perceived to have below-average corporate governance have come under attack from so called “short sellers”.
• The macroeconomic newsflow in the coming months may continue to cause market swings.
• In the coming months, we believe the roll out of pro-growth policies in EMs could be a significant tailwind to domestic demand in selected markets.

Market swings seem likely in coming months, but Franklin Templeton’s Emerging Markets Equity team is focused on corporate fundamentals and longer-term structural trends including digitalization and premiumization. Get the team’s latest outlook.

Three things we are thinking about today

1. Rising bond yields and a stronger US dollar. After falling to a low of 3.4% in early February, US 10-year Treasury bond yields have risen sharply over the past month as investor expectations of the terminal value for US interest rates moved higher. ¹ This led to an increase in the US dollar trade-weighted index by 3% over the same period. Dollar strength also weighed on sentiment toward emerging market equities, which have an inverse relationship with the level of the greenback. Higher US bond yields and interest-rate expectations have a negative impact on long duration assets, including technology companies. These companies, which have a high weighting in Asian emerging market indexes, tend to see downward pressure on their share prices as interest rates rise.
2. Renewed focus on governance. Selected companies in India and Hong Kong which are perceived to have below-average corporate governance have come under attack from so called “short sellers.” Aggressive accounting practices related to debt and depreciation policies are among the factors that short sellers highlight in justification of their negative views on these companies. We believe that investing in companies with good corporate governance, which includes factors such as conservative accounting practices, engagement with all stakeholders, and timely publication of annual accounts is the best way to avoid exposure to companies that are at risk from a short-selling attack. We also acknowledge that the perfect company rarely exists.
3. Slowdown in electric vehicles (EV) sales. Chinese EV and hybrid vehicle sales declined 6.3% in January. ² Chinese manufacturers have started to cut EV prices as sales soften, and in preparation for new product launches in the coming months. Balancing this negative factor is the weakness in lithium prices, a key input material for EV batteries, which have declined almost 30% from November 2022. Lithium prices have declined on weaker-than-expected demand and rising supply. Lower lithium prices is good news for EV manufacturers, where batteries can account for 45% of the manufacturing cost. ³

Outlook

The macroeconomic newsflow in the coming months may continue to cause market swings. Nevertheless, we remain focused on how the companies we invest in navigate these near-term uncertainties, as well as longer-term structural trends including digitalization and premiumization. Our investment team is focused on these trends in emerging markets (EMs), which we believe are likely to be the source of continued investment opportunities.

Over the last 10 years, we have witnessed increased EM investment opportunities due to stronger institutions, diversified growth drivers, and technological advancements. Electric vehicles (EVs), solar panels and semiconductors are a few examples. Currently, we see some of the existing trends accelerating, along with increased consumer spending power, which we believe will continue to be recurring sources of growth over the long term.

In the coming months, we believe the roll out of pro-growth policies in EMs could be a significant tailwind to domestic demand in selected markets. Across continents, local governments have introduced measures to cushion the impact of inflation and/or to spur consumption, and in turn, economic growth. In Latin America, Brazil will extend social welfare payments while Mexico and Colombia will raise the minimum wage, alongside Hungary and Poland in Europe. Some Asian governments are implementing tax cuts—the Philippines will extend lower tariff rates on eligible food items and Thailand will extend an excise tax cut on diesel. India will likely continue to prioritize capital expenditure to improve infrastructure, and has plans to venture into green tourism, where up to 50 new tourism destinations will be opened.

We believe that these policies, coupled with the presence of companies with exposure to new technologies that will drive future sustainable economic growth, present opportunities for the EM investor. EMs are home to both upstream and downstream firms in key technologies for the future including EVs, solar panels and semiconductors. Our focused investment approach enables our on-the-ground teams to identify business models and management teams that display agility and resilience in a fast-changing world.

What Are The Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.

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^1. Source: Bloomberg.

^2. Source: Fastmarkets, “China auto output, sales plunge in January after end to buyer subsidies exacerbates weak demand.” February 16, 2023.

^3. Source: McKinsey.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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