Uncertainty. Reduced visibility. Volatility. These are three themes that we believe will continue to dominate financial headlines in the months ahead, but—in an interesting turn—mostly in regard to the outlook for developed markets. In our view, the narrative for emerging markets is much more constructive.
From a macro perspective, a good deal of the uncertainty in today's global markets stems from U.S. policy risk. The U.S. Congress has been caught up in administrative procedures, such as confirming appointments from the new administration, assessing next steps on healthcare reform, and structuring potential changes to the tax code, leaving limited capacity for much else in the first half of 2017. Nonetheless, risk assets have had a healthy run since the November U.S. elections as investors signaled confidence in the new administration, with the caveat that any future policy changes that fall short of expectations could spark a repricing of those same assets.
Meanwhile, Europe remains a fertile ground for volatility as the Continent heads into a frenetic election season. Dutch and French voters have just elected new leaders, while their counterparts in Germany and possibly Italy are due to do the same in the next few months. Furthermore, on March 29, the British government triggered Article 50, kicking off what is expected to be an extremely complicated two-year Brexit negotiation process.
In addition, the global macro environment offers limited visibility on the future of monetary policies. Chatter has increased that the European Central Bank may reduce its bond purchasing program later this year, while the U.S. Federal Reserve continues to debate how and when to trim the size of its balance sheet.
Emerging markets look attractively valued
Despite the uncertain macro outlook in the developed world, our team continues to have a constructive view of emerging-market economies, particularly the main markets that we follow. Economic growth has ticked up globally and commodity prices—particularly oil—have stabilized; China's recent economic performance reflects these positive developments. We believe there's a reasonable chance that the growth differential between emerging and developed markets will widen or, at the very least, stabilize.
Most important, we think the asset class continues to look attractive relative to its peers. While emerging-market debt has staged a fairly steady recovery since early December, current levels still represent a slight step down from August and September of last year, pricing in a comparatively higher risk premium that we find attractive, all things considered.
Where we're finding opportunities: Latin American
Beyond the economic factors, the currency adjustment that took place in 2016 served to improve the terms of trade of a number of emerging-market countries—Brazil is a good example. The country, which is home to some world-class companies, has benefited from a relatively weaker real and stronger commodity prices, both of which have been supportive of Brazilian corporate debt issuers.
We also remain upbeat about Argentina, which we expect to post reasonable growth in 2017. The outlook for inflation has improved and political reforms appear to be headed in the right direction; as a result, we believe the country's credit rating is on an improving trend over the medium term. We've identified some opportunities in select local currency bonds. Emerging-market currencies have generally outperformed the U.S. dollar recently, and we believe the trend could continue, particularly if the U.S. dollar remains in its current trading range and postinflation, or real, interest rates in emerging markets remain attractive relative to U.S. real rates. These trends could translate into select tactical opportunities in the short term.
Seeking to mitigate the unknown unknowns
We believe that the biggest risks to the market continue to be the ones we don't know about. The ones that we know, however, we can get our heads around and anticipate; for example, unexpected U.S. dollar strength, new trade barriers, and higher-than-expected U.S. interest rates. At this point, we continue to believe that developed markets pose a bigger risk to the emerging-market universe than the usual gamut of risks typically associated with developing economies. From a policy perspective, it's important to monitor the current debate related to the proposed border adjustment tax. Its potential scope and complexity, particularly in terms of implementation, could have a far-reaching impact on trade and growth.
In the end, the global macro backdrop continues to be driven primarily by structural issues—debt overhang, low growth, and particularly low productivity. At this juncture, global investors appear encouraged by what we'd describe as a cyclical growth impetus—fueled by expected infrastructure spending, among other things—even as politics takes center stage. While not necessarily a negative development, it masks the fact that the developed-market structural issues we've previously highlighted remain unresolved, which could ultimately place a cap on future growth.
1 Emerging-market debt is represented by the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Index, a market-capitalization-weighted index that tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities. U.S. investment-grade debt is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. Prior to 8/24/16, the index was named the Barclays U.S. Aggregate Bond Index. It is not possible to invest directly in an index.