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Hasenstab's Guidelines for Emerging Markets

Ashley Redmond

Ashley Redmond: It's Emerging-Markets Week on, and we're going to speak with Michael Hasenstab, lead manager of the Gold-rated Templeton Global Bond. He is going to give us his take on some issues and opportunities facing global fixed income investors today.

Michael, thanks so much for joining us.

Michael Hasenstab: Thank you very much.

Redmond: Templeton Global Bond looks to identify countries with healthy or improving fundamentals, which has led you to some emerging markets. What are your criteria, and where have you found some of those opportunities?

Hasenstab: When we look at the global economy--and it doesn't just apply to emerging markets, it applies to developed markets as well. But specific to emerging markets right now, we're looking for a handful of characteristics that we think will present good long-term opportunities.

First, we're looking for economies with good macroeconomic fundamentals--so countries that have been progressing with structural reform, improving the productivity of their economy. A place like Mexico that most recently passed a number of labor reforms and educational reforms, and is undertaking energy reform. So they will improve the growth capacity going forward.

We also look for countries that have responsible fiscal policies. Since we are lending to those countries, we want to ensure that we can get our capital back, so we look for low levels of indebtedness, or in the case where the indebtedness is high, we look for a future path where that will be brought down and that there's fiscal commitment to appropriate policy.

We also look for a robust balance of payments. So we are looking for a trade sector that is competitive. We are looking for a country that has built large international reserves to be cushions, or insurance policies, against volatility in capital markets.

We also look for a consistent policy framework. We want the country to be working together, where the Ministry of Finance, the central bank, the elected leadership in Parliament are all on the same page and the country is going in a good direction. So, political consistency, policy consistency, good macroeconomic fundamentals, those are characteristics we are looking for, plus, good value.

So, I brought up Mexico. Mexico, we see a good policy framework. We see strong and improving growth conditions, and at the same time, we are able to earn a fairly attractive yield without taking a lot of interest-rate risk. So, those are the type of criteria that we are looking for.

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Redmond: There's notable concern about Fed policy and its effect on emerging markets. How are you perceiving this and its potential impact on your portfolio in future investment decisions?

Hasenstab: A lot of the market has this fear that when the Fed begins tapering or when the Fed begins to taper, there will be a dearth of capital in emerging markets and cause the implosion of many of these economies.

I think we need to take a step back on two fronts. First, tapering does not mean the withdrawal of capital. Tapering means no longer pumping additional capital into the pool. If we think about the global liquidity environment as a swimming pool, we've already pumped it well over full, and water is flowing over the edges. So what the Fed is talking about is just no longer pumping additional water into the pool. They're not talking about draining the pool.

Second, at the same time that the Fed is talking about no longer putting more water into that pool, Japan has just turned on the spigot, and they will be printing over $1 trillion over the course of the next year and flushing the world with additional global liquidity. The European Central Bank is talking about its own liquidity plans. Even though the Fed has stopped pumping, there are other major central banks that are moving to take over that.

And then when we look at the recipients of this capital in the emerging markets, there's a great degree of variance between those countries that are dependent upon global liquidity--Countries like Turkey, which have large current account deficits, they rely heavily on short-dated investments from foreigners--to place like Korea, which is actually a net capital exporter.

In fact, Korea has been exporting capital, not receiving capital in aggregate from the rest of the world. A country like Korea, with low levels of debt, a capital exporter, and higher interest rates, we see as very secure in an environment of Fed tapering.

The important thing is to understand what tapering really means. I don't think it's a dearth of capital. And number two is to then go country by country and ensure that we are invested in countries that should we see a tighter monetary environment, they can weather that.

Redmond: If these concerns are overblown, and by the sounds of it you do think they are, where do you think future opportunities may present themselves?

Hasenstab: Every time the market panics. Back in June, when the market panicked that Fed tapering was discussed in a serious effort, the market sold off in almost all emerging markets, whether it was Korea or Turkey or South Africa or Brazil. In periods like that, we go in and exploit that panic, and we add it to our exposure in a place like Korea.

As the market began to distill what this really meant, you see that the countries with the better fundamentals like Korea have now traded back to almost their [tighter spreads] over the last year, whereas some others have remained somewhat vulnerable.

We would expect in 2014 when we do actually see tapering, there will probably be periods of panic. And as we've done in the past, the investments that we think have good long-term value if the market scoops them altogether, and as the saying goes, throws the baby out with the bathwater, we will go in there and extract value in those periods of panic.

Redmond: Concerns about China shifting to a consumer-led economy has some investors worried. So what are some of the key drivers that investors should be focusing on in regard to China and its progress?

Hasenstab: First of all, I don't think we should be concerned about China shifting to a consumer-led economy. It's only natural as a country goes through a development path from low to middle to higher income, that the shift goes from a very investment-led economy to one that is more balanced, and China is in the process of shifting between primarily an investment-led model to one that is more balanced between investment and consumption, one that looks more like an advanced economy in the U.S. or parts of Europe. That's nothing to be afraid of. It's happened in every transitional country.

In terms of judging China's success at moving up that development path to becoming a high-income country. I think one of the most important components is financial market reform. There has been a lot of suppression, distortions, and subsidies in their capital markets. They've remained relatively closed. And that has allowed for control, but it has also caused some inefficiencies, some misallocation of capital.

If financial reform can be successful and liberalize interest rates, open the capital accounts, it will allow capital to get allocated more efficiently. It will prevent future boom/bust cycles. And so, when we look at the success or ability of China to move up that value-added chain, we think it is very much tied to their ability to implement successful financial market reform.

For China watchers out there, we would encourage people to look at the success or failure of financial market reform in China.

Redmond: Yield-seeking U.S. investors have increasingly been looking to put their money to work in global bonds. But what are some of the key differences between a U.S. bond and a global bond?

Hasenstab: I would say that the biggest would be in the search for yield in the U.S., a government-bond market, you have to take a tremendous amount of interest-rate risk to even get a 3% yield. Whereas in Korea, you can buy a less-than-one-year-maturity government bond and earn in excess of 3%.

Going global, you can still earn a yield, but you don't have to take a tremendous amount of interest-rate risk. Now, it's important to note there's no free lunch. There is no risk-free return out there above zero.

You do have to take risk, and in this case, you are taking foreign-government risk, you are taking foreign currency risk. We think it's a risk that you're being well-paid for, and in fact, we think it's an opportunity, because a place like Korea, unlike the Fed, is not printing its own currency.

So if you think about the value of currency over time, if you double the supply of something, it should decrease the value of it, and essentially that's what the U.S. has been doing with U.S. dollars by printing a tremendous amount of U.S. dollars. Or in places that are keeping interest rates almost at zero, you are not preserving that value.

Whereas a country like Korea, which is offering positive real returns and not printing money, we think over time, that will help preserve value and provide investors with a way to earn a yield and preserve capital over the longer term.

But it's always not going to be a smooth line. One does have to have a little bit of a longer-term horizon and expect some volatility along the way. But with an eye on a multiyear horizon, we think there are good opportunities to exploit volatility out there and position for the long term.

Redmond: Great. Thanks so much, Michael.

Hasenstab: My pleasure. Thank you.