Strategy Note / China

The Dollar leads Emerging Markets equities: The veteran's mantra

  • Stable US$ reduces fundamental FX rate and fund translation risks in EM equities and fund inflow trends mirror US$ moves
  • EM equity index performance is very correlated with US$ over the last 3 years, but much less so on 5-20 year time frames
  • Country mix changes in EM might explain this. China's dominance in EM index and rise of locals might weaken the US$ link

The mantra that I have heard in emerging markets is that any pitch for funds from asset allocators gets off the ground much more easily when everyone in the room (I guess, these days, I should say "on the call") agrees that the outlook for the US$ is stable and, ideally, weak. 

In contrast, a strengthening US$ forces EM equity fund managers to walk up a down escalator: the FX rates in the countries where their favourite companies operate face downward pressure (unbearably so for countries with external account vulnerabilities and low policy credibility), the risk is compounded if those companies rely on imported inputs where changes in costs cannot easily and promptly be passed on without destroying demand, and, to cap it all, there is an additional whammy from the translation of local currency public equity positions into a US$-denominated fund. 

At times it can feel that the thousands of lines of spreadsheet modelling produced by an EM portfolio team, built on hundreds of hours of meetings with management, utilising all their collective financial analytical, linguistic and forensic skills to determine the portfolio are trumped by the outlook for one variable: the US$ (which, ironically, most EM teams do not tend to forecast).

Correlation of US$ and Emerging Markets

A chart of net inflows into EM equity funds and the US$ (or, more precisely, the inverse of the US$), over the last ten years, suggests that both trend in the same direction.

When looking at the US$ (inverse) and the MSCI EM index over the last 20 years, it also appears that both trend in a similar fashion. However, the correlation of the US$ and the EM index is much greater in recent, shorter time periods (6 months to 3 years) than over longer ones (5 to 20 years).

This lower correlation over longer time periods may be a result of the significant changes to the country composition of the MSCI EM index. Not only is the MSCI EM time series ever changing but, as with most equity indices, the weight of successful investment stories grows over time ("survivor bias").

Challenges to the US$ and Emerging Markets mantra

As long as the world regards the US$ as a safe haven in times of global crisis (ie the US$ remains the dominant reserve currency) then it is safe to say that until the crisis passes (whether Covid-19, an oil supply scare, a geopolitical flash point, or all them at the same time as we have seen in 2020) then it is unlikely that local currency EM equities can outperform developed markets and global equity benchmarks (both of which are dominated by US equities). 

Outside of these crisis periods, we offer the following reasons why the mantra on the US$ and EM might be more challenged in future.

  • China – The weight of China in global GDP and in the EM equity index is approximately 20% and 40%, respectively. 
    • As China becomes a bigger driver of trade and cross-border investment the fate of countries in EM could become proportionately more linked, in terms of fundamental drivers, to the Renminbi (although the US$ translation link, in terms of how equity funds report their returns, would persist). 
    • Separately, if there is significant restriction on US institutional capital flows to China, as result of US foreign policy changes, then the EM index could move significantly for reasons completely independent of the US$.

  • Domestic versus foreign investor pool- The domestic investor pool, which is usually much more sensitive to total returns in local currency, rather than US$ terms, compared to the international one, may come to dominate (in terms of share of traded value on equity markets) as: 
    • Emerging countries grow more wealthy; 
    • Channels for illicit high net worth capital flight are tightened;
    • Domestic pension management becomes more institutionalised; 
    • Foreign investors ignore more and more of the "smaller" countries in EM (the big-3, China, Taiwan and Korea, already account for over 60% of MSCI EM); and 
    • Local interest rates (bank deposit and government bond yields) fall. 

Related reading

7 reasons to consider investing in small Emerging and Frontier Markets

Active investing in EM equity after Covid-19: A final chance against passive

US Dollar as reserve currency after Covid-19? A moot point for EM ex-China

Frontier-Emerging strategy: Benchmark, identity and confidence crises

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Macro Analysis / Global

Supporting FX markets during turbulent times

Refinitiv Perspectives
8 June 2020

COVID-19 has caused great disruption, not just to FX markets, but also to those who work within that environment and the way that they operate. How has Refinitiv, a market-leading provider of foreign exchange trading solutions, helped sustain the FX markets?

  1. COVID-19 has seen the normal working practices of the FX markets heavily disrupted, with many people conducting business from their homes. Refinitiv has ensured a successful transition to this virtual office environment (VOE) to support its clients and the wider FX trading infrastructure.
  2. Crucial to the success of this transition has been how Refinitiv has enabled its clients to have continued access to the trading platforms providing the liquidity needed across currency pairs and geographical regions.
  3. To further support the business continuity of its network of clients, Refinitiv has provided access to the trends, market insights and tools that will support compliance and best practice, and ensure the FX market ecosystem continues to operate smoothly despite the disruption.

Although the COVID-19 pandemic has dominated the news agenda in recent months, there have been other events that have affected the geopolitical landscape.

The simmering trade tensions between the major global economies, the Australian bushfires, and the crisis in the oil market have all added to market jitters across the world.

Volatile FX markets

For FX markets, the uncertainty has led to volatility that has not been seen since the vote on Brexit.

However this time round, volatility was not limited to market movements across G10 and Emerging Markets countries. Volatility also extended to the physical act of work — where we work from, and how we work — as many in the trading community found themselves working outside of their usual office environments.

Not within living memory have continuity planning measures been put in place on this scale across the FX trading buy-side and sell-side.

Supporting FX markets

At Refinitiv, we have ensured that we continue to support the market appropriately, no matter what the circumstances are. Across the world, our colleagues have been able to resolve client challenges within hours of them arising. And have done so while sitting on sofas, kitchen chairs, or deckchairs in their homes.

Access to liquidity

So far this year, the average daily volume across Refinitiv’s FX trading platform is around US$460bn, which is among the highest volumes facilitated by a single FX trading service worldwide.

FXall is the complete end-to-end solution for your FX trades

Considering the disruptive circumstances in which these volumes are being reached – and how our clients were able to find continued access to liquidity across the currency pairs and geographical regions needed — is testament to how effectively our partners were able to transition to virtual work environments.

Refinitiv’s network of clients, including almost every single major institutional FX trading firm (across the buy-side and sell-side), is connected to more than 2,300 institutional clients and nearly 200 liquidity providers through Refinitiv FXall.

FXall’s advanced workflow solutions and execution tools have been critical in helping the buy-side safely cope with much larger volumes from their remote or virtual work environments. FXall clients rely daily on a broad range of features, including:

  • Pre-trade order netting (including cross-currency netting and netting of same pair exposures that have different dealt currencies) to submit orders to the market for the most cost-effective execution possible.
  • Batch trading workflow and rules-based auto-execution, in order to automate all or portions of clients’ trading activity and increase operational efficiency.
  • Execution algorithms and other advanced order types that help users access liquidity in smarter ways, minimizing market impact as well as information leakage.
  • Sophisticated business intelligence to assess trading performance, identify improvement opportunities and enhance provider selection.
  • Regulatory reporting, audit trails and transaction history for robust risk management and compliance.

Similarly, via Refinitiv FX Matching, we are well established across more than 900 client sites and over 5,000 manual Refinitiv FX Trading users, making us the single largest ecosystem for FX transaction venues across the markets.

Business continuity support

Very early on during the disruption, we reached out to over 500 of our leading clients across the buy-side and sell-side. We wanted to understand how they are adapting to their virtual environments and the areas in which they might need help and support.

The insights gave us a fair representation of why the electronic trading venues that we provide are the essential cogs in keeping the FX global ecosystem up and running.

This was a test of our support, infrastructure and continuity services as well. For example, Refinitiv as a whole processed 176 billion updates on one day, when markets reached peak volatility in March. That is not just breaking a previous record, it’s obliterating it. The operational resilience and the way in which the entire industry is coping with this fast and sudden change is quite remarkable.

Market insights and compliance

With Refinitiv FXall Trade Performance Analytics, we have enhanced how buy-side clients can monitor market spreads, and build greater insights to help focus on transaction cost analysis (TCA) — an essential consideration during this disruption.

Access to liquidity and counterparties for our clients was an important consideration, but a further critical element of our strategy was to provide quick and easy access to the trends, market insights, and tools they required to ensure regulatory compliance.

The launch of Refinitiv Compliance Archive in partnership with Global Relay has helped ensure that we can provide archiving and compliance support for all ‘virtual engagements’ our clients undertake.

What lies ahead for FX trading?

Our vision and strategy for FX trading in 2023 is the cornerstone of gauging the progress made towards transforming the FX trading eco-system.

There are many releases on the horizon.

The introduction of APIs for Forwards Trading in Refinitiv FX Matching is based on the Spot Matching API that is already used by many FX participants. This new Forwards Matching API from Refinitiv will further support trading efficiencies and reductions to total cost of ownership (TCO) for Refinitiv clients.

In addition, with FXall Large Order Splitting, buy-side traders will soon be able to break up large orders into smaller child orders that can be executed using different execution methods, providing them with greater flexibility and control over their execution, while helping them minimize market impact and information leakage.

Meanwhile, by introducing liquidity aggregation via our Refinitiv FX Trading platform, and a faster binary feed for our Refinitiv FX Matching clients, we are ensuring that we will continue to be a market leader for many years to come.

FXall is the complete end-to-end solution for your FX trades

The post Supporting FX markets during turbulent times appeared first on Refinitiv Perspectives.

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Macro Analysis / Global

How is the European ETF landscape changing?

Refinitiv Perspectives
4 May 2020

Exchange Traded Funds (ETFs) have evolved from plain index trackers into important tools within the actively managed space. A panel, moderated by Lipper, has discussed ways to realize the potential of ETFs for retail investors in Europe, and how the ETF landscape is changing.

  1. Exchange Traded Funds are more than just passive instruments, with actively managed products able to use the structure of an ETF as a distribution wrapper.
  2. ETFs are regarded as the most successful innovation in asset management over the last decade, although they are actually a 30-year-old product in the United States.
  3. The distribution of ETFs is one of the main asset management challenges in Europe, particularly highlighting the potential of ETFs for retail investors.

Despite rough market conditions, February was another positive month for the European ETF industry as the promoter of ETFs enjoyed inflows.

The combination of below average inflows and a negative performance of the underlying markets led to a decrease in assets under management from €883.0bn as of January 31, 2020, to €839.9bn at the end of February.

Looking at the last two decades, the Exchange Traded Funds (ETF) landscape in Europe has changed from a world of ‘plain vanilla’ index trackers to a segment that enables investors to invest in nearly any asset class with a single transaction.

A recent Lipper panel, moderated by Refinitiv’s Detlef Glow, featured contributions from Thomas Merz, Vanguard; Michael John Lytle, Tabula Investment Management; Jürgen Blumberg, Goldman Sachs and Marlene Hassine, Lyxor ETF Research.

Actively managed products

ETFs are more than just passive instruments, with actively managed products now using the structure of an ETF as a distribution wrapper.

In addition, ETFs are no longer an investment vehicle used only by sophisticated professional investors for specific reasons.

The number of retail clients investing in them is steadily increasing. They use ETFs as core building blocks in their portfolios, which is something ETFs can do quite well since they are simple to use, simple to understand, and easy to buy.

In the asset management industry, ETFs are regarded as the most successful innovation in the last decade, although in reality they are a 30-year-old product in the U.S. that accounts for about 20 percent of the mutual fund industry.

Choosing the right ETF

In Europe, ETFs are only about five percent of the mutual fund industry.

Today, ETFs are not just a pure passive wrapper but are used flexibly, highlighting that the smart beta industry has grown to US$700 billion assets under management.

ETFs are used to deliver multiple strategies to the market since they offer instant execution and full transparency in the internet age.

Watch: ETFs in the asset management industry


Much remains to be done, however, to educate the European retail investor about ETFs and how to choose them appropriately.

The ETF landscape

In Europe, it’s still difficult to reach the retail investor.

The financial world’s entire ecosystem needs to be involved in distributing ETF products, possibly taking into account the success of robot advisors and online banks in Germany.

There is a huge potential for ETF sales growth among European retail investors that will be influenced by the regulatory environment and the captive way retail investors are intermediated.

A recent survey showed that retail investors are influenced by fund performance first, then marketing. Growth potential exists not only in increased usage of ETFs, but in asset size because a lot of money today sits uninvested.

Watch: ETFs and un-invested money


As long as ETFs are used to solve problems, the market will see a lot of inflows. What will drive the industry is if people believe they can make more money with these tools and gain access to things they would normally not be able to access.

Watch: ETFs and returns


The main challenge is the distribution question – how to reach potential new clients in an efficient way, in order to provide ETF tools.

Refinitiv Lipper fund performance data is rigorously independent, and is trusted by investment professionals worldwide

The post How is the European ETF landscape changing? appeared first on Refinitiv Perspectives.

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Macro Analysis / Global

Rates: Warning signs that equities might have it all wrong

ING Think
2 July 2020

What is the credit market telling us exactly? Stresses lie ahead

Very often credit spreads correlate with equity markets. As equity markets bottomed in late March, credit spreads peaked, just as the VIX did.

Here we find that the current theoretical default rate is in the area of 8% for one year. How does this compare with the great financial crisis? Well through 2008/2009 cumulative defaults were in the region of 15%.

The USD high yield CDS hit almost 900bp at the extreme, before falling back to a low in the area of 425bp. That is still above the pre-Covid levels in the sub-300bp area, but well below the explosive highs. That said, in the past month the spread has drifted wider by some 100bp, to the 530bp area. 

So what does a 530bp spread tell us?

Well the spread itself is a repercussion for being in a default-prone asset class. It provides compensation for taking business risk above and beyond the systemic risk-free rate. By the same token it can be used to back out a default rate expectation, and in fact as the spread changes over time, so too does the implied future default rate.

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Strategy Note / Global

Active investing in EM equity after Covid-19: A final chance against passive

  • Outperformance of large EM index weights, China and Korea-Taiwan tech, in the Covid-19 crisis suits passive funds
  • But China disruption from economic fallout and worsening US relations might be a final chance for active funds to shine
  • Failure to reach critical mass, not passives, is the problem in FM. More of a private equity-type mandate is needed
Hasnain Malik @
Tellimer Research
25 May 2020

As part of our look at the consequences of Covid-19, we focus here on institutional fund management in emerging market equities. Our view is that the disruption and dislocation of markets and business models may offer a last chance for active management in Emerging Markets, against the growing passive onslaught. For Frontier, the index may already be broken, and mandates which look more like private equity may be needed

Passive funds have been winning share from active funds for many years. In developed markets they now account for over half of the asset class. Drivers of this include lower fees, more sophisticated versions of passive (thematic passive funds), steadily rising markets, and the underperformance of the average actively managed fund.

And the rise of passive funds has made outperformance of actively-managed, bottom-up, fundamentally driven asset allocation more challenging, because the weight of passive flows – particularly when prompted by index changes – can overwhelm specific company or country investment cases and, all other things equal in a rising market and within a steady drop of inflows, the performance of passive funds can become somewhat self-fulfilling.

The vulnerability of passive funds should be greatest when there are major shifts in the backdrop of the market; breaks in the fundamental trends which have supported the largest components of an index. Passive funds have no defence against this, almost by design. 

Furthermore, the damage in performance can act as a reminder of the need to think longer-term, in terms of wealth creation; ie closer to the sort of time frame needed by successful, fundamentally-driven managers to achieve outperformance on the basis of a repeatable investment process.

So far the outperformance of China and Korea-Taiwan tech suggest passives will march on in EM

China and Korea-Taiwan Technology drive the majority of the weight in the EM equity index and EM traded value (liquidity). They also happen to be among the beneficiaries of China’s rapid emergence from Covid-19 disruption, the accelerated adoption of new technology across a range of services, and the gravitation of liquidity further into these dominant parts of EM during the current crisis. This should reinforce the outperformance of these largest index weights: all other things equal, this would suit passive fund strategies. 

Brazil, India, South Africa and Russia were already small relative to these markets and the likes of Saudi and Thailand were already too small to sway the performance of mainstream EM funds. The tail of irrelevant emerging equity markets (but sizeable countries and economies) for those benchmarked to the EM index has grown very long indeed.

But what if China on the cusp of one those major shifts to which passive strategies cannot easily respond?

However, we are sceptical that China can so easily recover (we find it incredible that infections, on official data, flatlined so early) and think that social distancing will reappear, that the shock to export demand has been felt fully, and that there will be lasting ripples in, for example, the shadow lending system, from the economic sudden stop. If this proves to be the case then this would equate to one of those periods when actively managed funds, positioned for this change in consensus view, could substantially outperform the passive comparators. 

Furthermore, the increasingly intense cold war between the US and China may present mainstream EM funds (both active and passive) with questions they have not faced before: will the weaponization of diplomatic, technology, territorial, and trade tools used by both sides in this cold war extend to capital markets and does that mean that, at some stage, there is a material risk that Chinese equities are deemed offside by US regulators? If so, that is not a question that passive strategies can easily take a view on in advance.

The challenge in Frontier and small EM has not been passives so much as failure to scale to critical mass

In Frontier Markets, the passive threat is much less advanced and should be much easier for active fund managers to defend against. A long list of factors suggest that actively managed strategies should outperform passive in small EM-FM: 

  1. Large swings in the country weights in indices such as MSCI FEM and MSCI FM (usually when a country is upgraded to EM) which drive disproportionate flows in and out of the stocks in those countries well in advance of the day those changes take effect.
  2. The loss of otherwise attractive investment cases at the stock level when that stock is removed from the index (eg as part of a country upgrade to EM).
  3. The high representation in indices of relatively mature companies or state-owned enterprises (which often do not have the most compelling investment cases).
  4. The extreme diversity of the investable universe (multiple geographies, languages, FX regimes, regulatory structures).
  5. High all-in trading costs (including commission, FX conversion, custodian, structured product access charges), and (vi) generally low trading liquidity (which inhibits the ability to easily trade in and out of stocks).

The biggest challenge for the small EM and FM asset class is that it has not yet reached a critical scale where asset allocators, as a whole, have to consider it and are drawn to individual funds by performance relative to a benchmark or peers alone. Instead the fate of a small EM and FM equity manager is perhaps much tougher; they need to substantially outperform DM and large EM and, ideally in more normalised environments, deliver positive absolute returns in US$ terms (regardless of DM and large EM performance).

FM may have to redefine itself as a quasi-private equity asset class, with much longer-lock up periods and the ability to invest in local currency and US$ sovereign bonds as well as public equity.

In the interim, small EM and FM equity markets likely return to being an almost entirely locally driven market where the catalyst for re-rating comes not, as it might have done in the past decade, from foreign investors but, rather, from local investors attracted to local equities when valuations relative to local bond yields and bank deposit rates become attractive.

Of course, for any small EM and FM fund able to withstand this crisis, the fruits of perseverance could be unrivalled; valuations are arguably attractive across the board (given the mainly strong balance sheets in every country’s bellwethers) and structural reform and growth themes should ultimately reassert. 

You can read more about how Covid-19 is reshaping the world in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.


Related reading

China and EM Tech valuation discount vs DM narrows ytd; not so for small EM-FM

Frontier-Emerging strategy: Benchmark, identity and confidence crises

7 reasons to consider investing in small EM and Frontier

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