Market Views: Will the appetite for EMs hold up?
The taste for risk is back. After pulling money out of emerging markets last year, investors are piling back into these markets with a vengeance.
This year, Investors have poured more than $86 billion into emerging market stocks and bonds, higher than what they placed in these assets in the last nine months of 2018 combined, according to media reports citing data from the Institute of International Finance.
That is quite a turnaround. In 2018, the MSCI emerging markets equity index dropped 14.6% as investors rushed to the exits as they fretted over the pace of future rate hikes by the Federal Reserve, slowing global growth, a Brexit stalemate and escalating trade tensions between the US and China.
Now, all signs indicate the Fed is turning more dovish, and more crucially, an easing-off in the US-China trade frictions is feeling like a distinct possibility.
Investors are clearly starting to feel more adventurous. Adding to the enthusiasm, on March 1, global index provider MSCI announced that it would increase the weighting of China A shares in its emerging market index to 3.3% from 0.72% at the end of eight months.
Then came more market-positive announcements on March 5 from Beijing, which announced stimulus measures, including infrastructure spending and cuts and taxes and fees to boost manufacturing and transportation.
All of this helped the benchmark Shanghai Composite index, which lost more than 24% last year to become the world's worst-performing index, climb 23.8% year to date (March 5).
Generally speaking, where China goes, the rest of the EMs follow. The MSCI emerging markets index has already jumped just above 9% this year.
So will this enthusiasm continue? We asked a fixed income head, a quant specialist, a multi-asset expert and a chief investment officer for their takes on how they see EMs versus developed markets and whether the allure of emerging nations will continue.
The following have been edited for brevity and clarity.
Adam McCabe, head of Asian fixed income
Aberdeen Standard Investments
With the global headwinds of 2018 waning, emerging market assets should be poised to fare better in 2019. The growth differential between EM and developed markets is set to increase due to slowing US growth, benefitting EM currencies, which have historically been correlated with this difference, and are still undervalued in real effective exchange rate terms by historical standards.
Should the global growth environment weaken, driven by China and the US, and soften the backdrop for commodities, the disinflationary impact will be positive for local bond markets in economies that are substantial oil importers (although softer oil prices would weigh on oil exporters).
This is particularly beneficial for Asia, including countries like India, Sri Lanka and the Philippines.
EM hard currency sovereign spreads have done well in the last few months, helping investors avoid potential volatility in local currency markets. Looking across Asia, India and China have been good diversifiers and Philippine bonds have been another attractive idiosyncratic trade.
Given how flat yield curves are, short duration credit, both local and hard currency [bonds] are also attractive. The continued deleveraging of EM corporates and improved interest margins will keep default rates low.
The key risks ahead for EM debt are continued dollar strength, persistence of US exceptionalism, an early resumption of Fed hikes, a deeper China slowdown and a further escalation in trade tensions. While election risk is lower this year, there a few notable ones to watch in Ukraine, South Africa, India and Argentina.
Paul Sandhu, Apac head of multi-asset quant solutions and client advisory
BNP Paribas Asset Management
Led by Asia, emerging markets racked up significant gains in the two years leading up to the beginning of 2018; the MSCI emerging markets index gained nearly 60% in two years. This was a pivotal time in the market, as trade tensions worsened and anti-globalisation sentiment was being put into practice.
But as we moved towards the end of 2017, the market was hit with large negative drawdowns, which became the norm for all markets except the US, where drawdowns were quickly followed by recovery. Given this dynamic, we could be seeing an opening to allocate into markets which have seen the most negative impact - emerging markets.
The strength of correlations between emerging market segments and developed markets has recently dropped by nearly a factor of two when we look at 15 years of historical data. This, in traditional market terms, could be construed as a flight to quality. However, some would say it is a consequence of a move towards closed markets globally. This creates an interesting dynamic, whereby correlations of asset classes within markets increase, while correlations across markets decrease.
For example, in credit markets, we have witnessed overall spread compression. That means risky assets are not so risky and less risky assets are a little more risky, making them increasingly difficult to distinguish in asset allocation.
In 2019, stability in the dollar will provide a potential entry opportunity into emerging markets. China’s A-share inclusion in the MSCI emerging market index may have just made the index more connected to US-China trade talks. But I would argue that this makes the case for utilising emerging markets as a diversification tool even more compelling, especially for investors who currently have a large allocation to the US.
Stefan Lowenthal, CIO for global multi-asset solutions
Macquarie Investment Management
From our perspective, both EM equity and fixed income offer attractive valuations, especially in comparison to developed markets, although we are waiting for confirmation that data is stabilising (as it seems to have in recent weeks).
Having invested in EM local currency bonds for quite a while, we added some EM exposure since the beginning of this year, especially in EM equities and, after the US Fed’s U-turn [in guidance], in EM hard currency bonds. But we were hesitant to implement significant overweights due to ambiguous macroeconomic data recently.
Within EMs, we currently deem equity as the most attractively valued asset class, with EM local currency bonds coming in second and hard currency [bonds] third, on a risk-adjusted basis.
Within EM equities, conventional wisdom has it that the IT sector has gained importance while that of commodity-related sectors has diminished. More importantly, the positive commodity correlation with EM equities has decreased. This might have been driven by the rise of China, which increased significantly in weight in the MSCI [emerging market] index and at the same time is a net importer of many commodities. As a result, in our view, EM and commodities have become very different asset classes.
Both from a valuation and a risk perspective, Latin America and Eastern Europe look more compelling than Asia. EM Asia is much more tied to China/Chinese growth, and given the political risks lately in some Latin American and Eastern European countries, these markets now trade at more attractive levels.
Within EM local currency bonds, we think currencies outside the traditional benchmark indices are quite attractive, as they tend to be less correlated and, therefore, offer diversification benefits.
Sean Taylor, Asia Pacific chief investment officer
DWS
We believe that emerging markets offer upside this year and have upgraded EM equities within our global equity view. This is because valuations are extremely cheap after the sell-off last year, and a number of the headwinds of last year should fade in 2019.
We see five key drivers for returns and the asset class over the medium term. First, most of the Fed hikes have been done, and we see a pause in the hike profile with only one hike in 2019, likely only in the second half of 2019. Slightly moderating US growth and lower Fed expectations should stabilise the US dollar, alleviating EM forex pressures.
We also see positive momentum for markets on clearer US-China trade details. The Chinese economy is also being supported by positive policy, a turning point since the last quarter of 2018, which is helping to stabilise China’s growth outlook. We see a policy bottom, but are yet to see an economic trough – we still have 6% GDP growth for 2019. Finally, contagion fears in emerging markets have diminished post a positive Brazilian election outcome.
The recent rally in emerging markets has largely been a re-rating rally after last year’s de-rating as Fed hike expectations have been priced out, improving the liquidity outlook and sentiment.
We like EM equities as an asset class as well as EM sovereign [bonds].
Within equities, we have an MSCI EM index target of 1,100 by March 2020 which includes around high single-digit earnings growth. Within EMs, we like Asia Pacific, including China and Thailand, while also preferring Brazil and Russia.
This story has been updated to include DWS's comments.