A wobble across emerging market (EM) assets due to tightening financial conditions and geopolitical tensions has tempered enthusiasm for the asset class. Yet broader fundamentals are robust, and we believe the draw-down presents buying opportunities. We prefer EM equities and selected hard-currency debt.
EM assets are no longer under-owned. Cumulative flows into EM debt and equities have recovered steadily since early 2016, following an extended period of outflows. The reversal is most dramatic in EM debt, as the blue line in the chart shows. A benign global economic backdrop and chunky yields spurred income-hungry global investors to pile into EM debt through 2017. Resilience to shocks such as February’s equity volatility surge drew in more investors at ever-richer valuations. This left bonds exposed to sentiment shifts. Flows into EM equities have been relatively subdued, by contrast, as the green line in the chart shows. We favor EM equities on strong corporate earnings and the relatively healthier balance sheets in Asia. We see room for equity inflows to ramp up in coming months.
EM assets have suffered a setback over the past month. Rising U.S. short-term rates, a stronger dollar and worries about external debt loads in Argentina and Turkey sparked an unwind after months of solid inflows. EM currencies, down more than 3% in aggregate this year against the U.S. dollar, have borne the brunt of the selloff. EM equities have given up all their early 2018 gains.
Has the tide turned? We do not see a repeat of last year’s heady returns. But several trends underpinning the relative appeal of EM assets are intact. Our BlackRock Macro GPS points to the synchronized global expansion carrying on through 2018. Chinese growth has exceeded expectations and authorities have shown a willingness to loosen policy to stave off any sharp slowdown. A windfall from higher commodity prices has helped many EM countries bolster their current accounts. Equity valuations have fallen to less than 12 times forward earnings. And corporate earnings growth is expected to clock in at more than 20% over the coming 12 months.
The outlook for EM debt is murkier
The asset class’ skew toward regions with weaker government balance sheets dampens its appeal. Tighter global financial conditions have unmasked vulnerabilities among countries with large external funding needs. Worries about a populist victory in the July Mexican elections and uncertainty about upcoming votes in Brazil and elsewhere have stoked currency volatility. We prefer dollar-denominated EM bonds of countries with little need to raise funds. Yields on hard-currency EM debt have risen to converge with local-currency debt yields for the first time since 2009, providing an attractive entry point.
What are the risks?
A sharp rise in the U.S. dollar or interest rates, causing further tightening in financial conditions, or an escalation in global trade tensions. Neither is our base case. We see the U.S. dollar’s upside capped as major non-U.S. central banks prepare to wind back policy support. We also see limited scope for a full-blown trade war. Robust corporate earnings support our preference for equities. We like emerging Asia and Brazil.
We see EM equities offering value in a world where value is scarce.