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Emerging market debt: an end to the agony?
By Advisor Perspectives
Capitulation by many EMD investors has created opportunities in many of the more resilient countries.
We favor countries moving down the reform path and where there is significant impetus to reign in excessive government spending.
Valuations have reached the extremes that allow a selective approach to EM to now represent a key part of an income-oriented portfolio.
Emerging markets (EMs) have endured a miserable year. Slowing Chinese growth, collapsing commodity prices, rising indebtedness and geopolitical turmoil have all taken their toll on fundamentals. The worsening EM story has, in turn, had a negative impact on capital flows, impacting performance both in absolute terms and relative to developed markets.
More recently, China’s devaluation has led to fears that deflation could be exported to the rest of the world. The haphazard nature of China’s policy response to the economic downturn has weakened investor resolve that Chinese authorities can engineer a "good" outcome. The problems do not end there. The Federal Reserve is stating a desire to tighten policy, prompting concerns that a continued rise in the U.S. dollar will undermine EM local returns.
Unsurprisingly, sentiment toward emerging markets has soured. The above trends are self-reinforcing, prompting many to call for EM to enter a protracted period of weakness. Given all the uncertainties, should investors simply ignore EMD altogether, or might a more selective approach to EMs produce better results?
It is far too late in the cycle to “give up” on emerging markets
Abandoning EMD altogether is akin to throwing the baby out with the bath water. The adjustment in EM assets is hardly new, and underperformance has been marked since at least 2012. Consider Brazil — a constant source of discouraging news. Brazilian equities, as measured by the Ibovespa, are down by 36% over the five years ending September 30 in local terms. For a U.S. dollar investor, however, depreciation of the Brazilian real has pushed the return to -71.7% over the period. Local rates in Brazil have risen to over 15%. Other markets — in USD terms — have also posted deeply negative returns. Russia, Ukraine, Turkey and Argentina have all endured periods of notable stress in the last 24 months.
Prices could, of course, move lower, but valuations suggest that EM challenges are well-recognized in the market. We fully expect a protracted period of emerging market economic weakness, but we are at a stage in the current cycle that demands a focus on dislocations and valuation. Many opportunities appear compelling. EM growth will be positive and will continue to exceed developed market growth (Exhibit 1), notwithstanding the risk of further downward growth revisions that have dominated this cycle (Exhibit 2). This is a recipe for further volatility, despite much-improved valuations.
Exhibit 1: IMF GDP growth forecast — advanced economies
Sources: Columbia Threadneedle Investments, IMF, 07/15
Exhibit 2: IMF GDP growth forecast — emerging economies