‘The prospect for emerging markets much better than for developed markets’
Emerging Markets (EM) have performed a lot better this year than for some time. EM currencies are outperforming the dollar and EM local bonds are up strongly year to date in dollar terms.
Despite this rally EM bonds still pay a yield five or six times higher than similar duration bonds in the US, while many other developed market bonds pay negative yields.
The reasons for EM’s better performance are many, including better valuations, stronger technicals and improving relative and absolute fundamentals. As recently as last week, the IMF revised down developed market growth again, including -0.2% revisions of US and UK growth. China’s growth forecast was revised up.
We think most of the fears pertaining to EM are misplaced and that it is ok to allocate to EM now, despite the uncertain outlook in developed economies:
- Resilience in the face of external shocks: EM countries have faced major external headwinds over the last several years, including the Taper Tantrum, the strong dollar, a commodity price crash and the start of the Fed’s hiking cycle. Many investors panicked in the face of these shocks, but EM fundamentals held up better than most expected. Default rates remain low, central banks did not lose control of inflation and balance of payments crises were few. This combination of lower asset prices but resilient fundamentals has created value in the asset class.
- Stronger external balances: There is now overwhelming evidence that EM’s external balances have dramatically improved. Weaker EM currencies have helped to restore external competitiveness, while central banks have controlled inflation in the face of pass-through inflation risks. Nowhere is the improvement in external balances more evident than in EM’s sharply improving current account balances. This bodes well for both reserve accumulation and growth.
- The return of the EM growth premium: EM economies are now emerging from the cyclical slowdowns caused by capital leaving in order to chase Quantitative Easing (QE)-sponsored rallies in the developed markets. EM’s growth premium over developed market growth is now expected to rise consistently over the next five years, mainly due to net export performance.
- Latin America: Having been beaten up more than any other region during the headwinds of the last few years, Latin America now offers perhaps the most interesting investment proposition in the world. Institutions are improving, populist governments are giving way to more market-friendly administrations and asset prices are cheaper than elsewhere. In our view, Latin America will also see a more extreme turn-around in growth than other regions over the next couple of years.
- The rise of the judiciary: The rise of middle classes is changing EM. Elected officials are facing far more careful scrutiny by judges across a number of countries. This is perhaps most evident in Brazil, but similar dynamics are evident elsewhere too. While the judiciary is not winning in all EM countries the trend towards greater accountability at the hands of increasingly powerful judges is nevertheless likely to strengthen as living standards continue to rise.
- Attractive valuations in a number of EM asset classes: The relative and absolute valuations in EM are compelling after years of selling by asset allocators as they have chased QE-sponsored developed market assets. EM IG corporates now offer superior returns and lower risk than US IG corporates across time periods, maturity and ratings buckets. The risk return profile for EUR denominated EM bonds also strongly favours EM over eurozone sovereign bonds. EM corporate high yield bonds have lower default rates than US high yield bonds and a number of arbitrage opportunities now exist in external debt, including about 100bps of free spread due to the greater diversification of the index following the doubling of the number of issuers over the past decade.
- Excellent technical: The bulk of retail, fast money, banks, hedge funds and other momentum investors are out of the asset class or very lightly positioned. Institutional investors have in many cases not allocated in line with the growth of their AUM over the last few years. The resulting strong technical position has made the EM asset class more resilient in the face of several confidence shocks this year, including the pricing of future Fed hikes and Brexit. This suggests the EM rally has legs, even though markets never move in a straight line.
- Diminishing sensitivity to Fed tightening: Fed hikes are still perceived by many to be the greatest threat to EM. Yet correlations between EM rates and FX and the short end of the US Treasury curve have been declining steadily and are now very low. EM pullbacks in response to Fed tightening have become steadily shallower, while recoveries after Fed events have become stronger. EM bond yields are already hovering close to levels last seen when the Fed had policy rates above 5%, so the likely gentle trajectory for Fed hikes should not hurt EM. By contrast, there is clearly vulnerability in developed fixed income markets, where debt burdens are higher and bond yields far lower. Indeed, developed market bonds are showing increasing sensitivity to Fed tightening.
- Good tactical entry point: Spikes in risk aversion in developed economies have usually been good entry points for EM allocations. Brexit caused a 10 point spike in VIX (volatility index). In the past, VIX spikes of 10 points or more have produced on average 3% alpha over the subsequent 12 months compared to passively timed investments.
- Less attractive alternatives: The opportunity cost of investing in EM is declining sharply, because yields in developed markets are going negative almost across the entire term structure. Investments in developed economies are also becoming riskier, because reforms are being neglected and the ability of developed countries to stimulate their economies in conventional fashion is diminishing. The next generation of easing measures could be painful for investors.
- Rising political risks in developed economies: Investors were recently reminded that investments in developed economies can be far from risk-free. The GBP, a global reserve currency, experienced a 21 standard deviation shock in the immediate aftermath of the UK Brexit vote. But Brexit is merely one manifestation in a broader shift towards more populism in developed economies and there are likely to be many more. Populism will lead to policies that directly hurt economies, while the crucial ingredients that could engender a genuine economic recovery, such as deleveraging and aggressive economic reforms, get set aside. This means risks are increasing, boding poorly for return prospects.
- A lot of alpha opportunities: The universe of sovereign issuers in EM will reach 67 or higher this year. There are more than 3,000 corporates in the BAML (Bank of America Merril Lynch) EM corporate bond index. Right now, the ‘live’ opportunities include Venezuela, Brazil, China, Russia, Turkey, Malaysia, Argentina, Ecuador, Indonesia, India, Mexico and others.
Jan Dehn is head of research at Ashmore