Over the past few weeks, we’ve seen significant volatility in the markets, which has spooked some investors, but is also something we have become accustomed to. Markets generally (not only emerging markets) have become much more volatile during the last 20 years as a result of massive flows of money from not only institutional investors and long-only mutual funds but also hedge funds and high-frequency trading. We see such selloffs as potential opportunities to pick up bargains in select stocks if, in fact, the prices move low enough to draw our interest. We have found, however, that these kinds of fluctuations have, in the past, been generally short lived.
For short-term investors, the type of selloff like the one we have seen in the markets recently can bevery worrying. That’s why, to some degree, we will see money quickly jumping out of what are deemed to be “risk assets,” which include emerging market equities. But I think most long-term investors realize that they need to think before they leap, since recoveries can come very fast and it can be difficult to get back in when the recovery comes. The bottom line for emerging markets, as I see it, is that the long-term investment case hasn’t dramatically changed. And I don’t see it changing as long as these three themes remain in place: emerging markets’ economic growth rates in general continue to be at least three times faster than those of developed markets; emerging markets have much greater foreign reserves than developed markets; and the debt-to-GDP ratios of emerging market countries generally remain much lower than those of developed markets. Of course, there are notable outliers given the many and varied emerging countries, but we believe those basic facts auger well for the emerging markets’ long-term prospects.
At Templeton, we’ve repeatedly championed our value-driven philosophy by frequently buying at times others are most pessimistic. This is not easy to do. During the past few months, emerging markets have been subject to such pessimism. These periods of volatility are certainly not new to us and don’t change our long-term conviction of the potential that emerging markets hold. We feel recent declines have been overdone and based largely on irrational investor panic, and have viewed the recent pullback as an opportune time to search for bargains for our portfolios. We find valuations in many emerging and frontier stocks particularly attractive right now.
Thoughts on China, and Argentina
Two markets cited as triggering some of the panic that has spread to emerging markets broadly are China and Argentina, so I’d like to address those cases specifically here.
Worries again are surfacing about the pace of growth in China after some disappointing recent economic data. As I see it, critics of the Chinese government seem desperate to find something wrong in China and have latched on to the idea that China’s growth is slowing. The reality is that China is still growing at a very rapid pace. If China can achieve a growth rate in the range of 6% – 8% this year, it would be incredible for any economy of that size; the US, Japan and other leading developed countries are far away from that growth rate. As the Chinese economy grows and transforms, we can’t expect the double-digit growth rates of the past. There will be deceleration—but that’s okay. In terms of dollar value, the increase in China’s gross domestic product is very high. And, China is embarking on a number of important reforms as it moves toward a more domestic-driven economic model.
Regarding Argentina, at this stage of the game the government has acknowledged that there is a problem with the competitiveness of the peso (ARS) at the official foreign exchange (FX) rate. After having lost some US$20 billion in reserves, the government decided to take its medicine, devaluing the currency and easing restrictions on the purchase of US dollars for the first time since currency controls were put in place in November 2011. The official FX rate jumped to ARS 8 / USD from the ARS 6.8 / USD level during the week of January 20, but still far from the thinly traded parallel USD black market rate – known as the “blue dollar” rate, which was trading at ARS 13 / USD. The problem is there are too many ARS chasing (wishing to purchase) USD at the current Argentinian interest rates (20%). Since President Cristina Kirchner came back to office after her surgery and the change in the Cabinet she endorsed, the Argentinian government has lost US$2 billion of its reserves.
As I see it, there are several questions that need to be answered. One relates to implementation risk of the devaluation. We think Argentina’s currency depreciation is necessary, but it is questionable how the government is accomplishing it. In our view, one of the objectives of the policymakers must be to abolish the capital restrictions so that US investment dollars are encouraged to enter the country. There is a considerable pressure on reserves, and I think the government cannot allow that unless it is able to convince investors to remain in ARS. With the parallel rate at around ARS 13/USD and the interest rates at 20%, in our view, the official rate should be closer to ARS 10 / USD. If interest rates are allowed to reach 40%, we believe the official rate should be around ARS 9 / USD, which is not that far away from where it is now.
If the government does not allow interest rates to rise, in my view, the devaluation will not stop the outflow of reserves; it will only buy time. The timid ease in the restrictions to purchase USD for retail investors appears to be an attempt to reduce the demand in the parallel market that provides the basis for the gap between the official and the parallel rate. The government seems obsessed by the official/parallel market gap, but it doesn’t seem to be doing anything to tackle the issue that we think put Argentina in its current situation: fiscal mismanagement and the resulting inflation. This brings us to the second point: fiscal adjustment. The government has been issuing 35% of the monetary base to finance the government. Some forecasters estimate that the 2014 fiscal deficit could reach 5% of GDP. I think the government must freeze public spending and apply a brave utility rate adjustment. In combination with the devaluation, the flow of ARS to the system must be restricted or investors will continue to believe that the recent devaluation was not the last one.