Emerging-market debt: down, but not out
The headlines relating to emerging markets over the past three months remained largely negative, focusing on wild market moves, uncertainty relating to slowing growth in China, the impact of slumping commodity prices, and sustained capital outflows from these economies. But look a little deeper and it isn't difficult to find signs of stabilization.
Although emerging markets suffered from a steady stream of investor withdrawals in 2015, more recent reports have shown a stabilization of asset flows, if not a turn toward net purchases.1 In fact, investors recently added over $2 billion to U.S. exchange-traded funds (ETFs) that buy emerging-market stocks and bonds, the highest amount in almost two years.2
To be clear, the outlook for emerging economies still calls for headwinds: Corporate debt levels remain elevated, while the impact of currency gyrations and limited liquidity could potentially compound the impact of any potential negative developments.
But it's important to remember that emerging economies are much more than the sum of their widely reported woes. These economies boast demographics that their developed peers can only be envious of. As a group, they also have much lower debt-to-GDP ratios and, crucially, the number of countries with a hard currency peg to the U.S. dollar has fallen dramatically in the last three decades, even as foreign reserves have grown.3
Finally, even if the International Monetary Fund's projections prove correct and the combined growth rate for emerging economies only improves slightly from 2015 to reach 4.3% this year, that kind of growth would still be a better showing than in virtually all other developed countries.4
Risks do exist, and four loom large
Among the material list of risks to emerging markets, four in particular stand out in our minds:
1 Ongoing weakness in commodity prices. Commodity-derived revenues have a direct influence on the fundamentals of many emerging-market economies. While we're starting to see signs of stabilization, there's no getting around the fact that it will simply take time before we know whether February's uptick in prices reflected a bottoming in the market. Nonetheless, we believe commodity prices will head higher in the medium term, supported by rising demand from the rising middle classes of the emerging economies.
2 A hard landing in China. We believe Beijing will be able to manage the various challenges the Chinese economy is facing with the introduction of appropriate monetary and fiscal policies. Nevertheless, the probability of a hard landing— however small—still exists. We'll continue to monitor developments closely.
3 Aggressive rate hikes from the Fed. The likelihood of multiple imminent rate hikes from the U.S. Federal Reserve (Fed) appears low at the moment; however, as Fed Chair Janet Yellen is fond of reminding us, it's all data dependent. We'll be monitoring U.S. economic data closely for any sign of price inflation that could nudge the Fed to make a move before its scheduled June meeting.
4 Continued volatility in high yield. Given the high correlation between U.S. high-yield bonds and emerging-market debt, a significant widening of spreads in the former could be seen as a signal to investors to take down risk levels in their portfolios. This could have implications for how investors view emerging-market debt, and any loss of risk appetite, which is already fairly low, would likely lead to a sell-off in the asset class.
Select opportunities exist for active—and patient—investors
For years, one of our mantras has been that emerging markets should no longer be viewed as a single trade. The opportunities in the asset class are far from uniform, and finding compelling countries, sectors, and securities requires fundamental research.
With that in mind, we remain constructive on our outlook for Brazil. We believe the country has moved closer to resolving the political crisis that has cast a shadow on its economy in recent months and that progress is beginning to be reflected in the valuation of its debt. While over the shorter term we expect volatility, medium term, the political changes are profoundly positive. Brazil's is a dynamic and exciting economy, and although it faces significant challenges, we believe that the upside is being overshadowed by the country's political turmoil.
We also hold a positive outlook on Mexico. The country has a diversified economy and is home to a very strong manufacturing sector, which benefits from close ties to the U.S. economy. Mexico's manufacturing sector is home to a number of strong domestic players, some of which have made the leap to become regional and global market leaders. The government's decision to impose spending restraint in order to rein in its budget deficit at a time of low economic growth is laudable, as is its commitment to reforming the country's energy sector, a development that could lead to enhanced competition and increased foreign investment.
Over in Asia, Indonesia has surprised to the upside with its continued commitment to economic reform. The rate of progress has been impressive, considering the amount of negotiation that needed to take place to get all the necessary political players on board. The first wave of the current reform agenda has taken place, and preparation for the next wave, which is likely to be slower to implement, is already under way. We think Indonesia has quietly outdone India on this front, despite not getting as much attention or credit for its efforts.
For investors with longer time horizons and a tolerance for risk, we think emerging-market debt may be worth a closer look. While there are few mispriced opportunities on our radar, at current yields, we do believe investors are being fairly compensated for the risks in the market. We also believe it's more likely that growth in emerging markets continues to lead the world than it is for us to see a material deterioration in fundamentals going forward.
1 EPFR Global, March 2016. 2 “Emerging Market ETFs Surge $2.72 Billion, Turn Positive for the Year,” Bloomberg, March 2016. 3 “Emerging markets' rout ‘different' from crises of 1997–98,” the Financial Times, August 2015. 4 “World Economic Outlook Update: Subdued Demand, Diminished Prospects,” IMF, January 2016.