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Luxury goods, carmakers and pharmaceuticals derive a higher proportion of revenues in developing countries. Photo: Bloomberg

Sovereign funds wary of emerging market volatility

Opportunities to be had as sector can ride out the swings thanks to its long-term horizons

Sovereign wealth funds see emerging market turbulence as a long-term buying opportunity, but are wary of excessive exposure via some of their Western holdings such as luxury goods makers, a top investment official at Franklin Templeton said.

David Smart, who heads a team managing sovereign funds and supranational clients at Templeton, said the US$5 trillion sector could afford to ride out volatile swings thanks to its long-term horizons.

"In terms of our client base, we haven't seen any evidence of de-risking," he said. "If anything we've seen willingness to take advantage of opportunities. They have the ability to withstand volatility. They see it as a long-term acquisition opportunity."

But the funds, many of which manage windfall oil revenues for future generations, are shifting their approach to emerging markets, having treated them as one homogenous group for many years.

I’m not being negative … it’s merely a degree of risk-factor awareness
DAVID SMART, TEMPLETON

They are now reframing allocation with a focus on how much of their holdings are truly exposed to the emerging world in underlying economic, not just geographic, terms.

One way to do so, Smart said, was to use measures such as index provider MSCI's Economic Exposure Index.

The index provides a measure of companies' economic exposure - sensitivity of a firm's performance to economies in which it operates - using the geographic distribution of its revenues, regardless of where it is based.

"A number of them are looking at (the index). There's a great deal of awareness about it ... I'm not being negative on emerging markets but it's merely a degree of risk-factor awareness," he said.

For example, having too many European companies which sell a lot of products in emerging economies would push up a fund's overall economic exposure to emerging markets.

Luxury goods, car manufacturers and pharmaceuticals were the three sectors which derived a higher proportion of their revenues in developing countries, Smart added.

For example, luxury fashion brand Christian Dior is listed in France but at least 40 per cent of its revenues come from emerging economies.

"Our approach is to be cognisant of the fact that you already have, on the MSCI developed index basis, some 21 to 22 per cent of exposure to EM in economic terms," he said.

"You can make sure you are not double allocating to emerging markets."

The MSCI Economic Exposure Index for Europe, which measures the economic exposure of European companies to emerging markets, has fallen 3.6 per cent this year, compared with a broad European gauge which is flat.

An anti-corruption drive in China and a general economic slowdown in other emerging markets have dented sales of luxury goods from high-end watches to the logo-printed products sold by the likes of Louis Vuitton or Gucci.

Smart, whose clients include central banks, said that currency reserve management was becoming more divergent, with one group pursuing liquidity to be ready to intervene in local markets and the other trying to achieve their return target, typically of about 3 per cent to 4 per cent plus inflation.

Data earlier this month raised eyebrows as foreign central banks' overall holdings of US Treasury debt fell by US$104.5 billion to US$2.86 trillion in the week ended March 12.

That underscored the appetite of central banks such as Russia and Turkey to liquidate their Treasury holdings to supplement their decreasing foreign reserves and help support local currencies.

And others may also be tempted to keep liquid investments such as Treasuries as a contingency.

"If you need to intervene to the tune of US$10 billion to US$20 billion to stabilise your currencies, it's really Treasuries and gilts that offer instantaneous liquidity," Smart said.

"But there's a big carry cost to having cash. A lot of my clients ask about how to hedge inflation risks on a five- to 10-year horizon. Inflation is a nasty scenario for all developed market government bonds."

This article appeared in the South China Morning Post print edition as: Sovereign funds wary of emerging market volatility
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