Multi-Asset Insights: Emerging markets' vulnerability demands focus on quality
Continuing the emerging markets (EM) theme from last month, when we shared our views on how economically vulnerable EM may be in an environment of rising US interest rates, this month we provide an expanded update on our views across EM risk premia.
In general, we believe that EM are in an economic malaise driven by a myriad of issues which may require a multi-year healing process.
EM equities, as measured by the MSCI Emerging Markets Index, have fallen to a four-year low since reaching a 12-month high in May.
Looking beyond index performance, we find that much of the underperformance and improving valuations in EM equities can be attributed to commodity-related sectors.
This suggests that assessing value in EM requires taking a view on commodity prices and the prospect of a Chinese cyclical recovery.
However, our commodity risk premia group remains cautious on broad commodities and we are therefore reluctant to take a positive view on EM equities until we see value more broadly across the universe.
Figure 1 shows the relative 12-month performance (compared to the S&P 500 Index) of the EM universe by themes and highlights the severe underperformance in EM commodities sectors.
Recent action by the People’s Bank of China (PBOC) suggests that the risk of a serious downturn in China has increased, which is a warning sign to us that the desired China cyclical recovery may not be within reach yet.
We therefore remain negative on broad EM equities.
Both hard and local currency denominated EM bonds have struggled since April.
While limited EM growth and concerns about sector flows will hinder emerging market debt (EMD) performance, we expect a relatively tame Federal Reserve (Fed) hiking cycle will be partly offset by continued accommodative monetary policy in the eurozone and Japan.
EM external debt has been relatively resilient so far in 2015, supported by healthy fundamentals and stable inflows.
We still prefer hard currency to local currency bonds and expect high quality assets to outperform during this period of heightened volatility.
EM local debt is much better positioned for the beginning of rate rises than prior to the ‘taper tantrum’ in 2013.
We retain a neutral view on EM hard currency spreads over US Treasuries and expect the attractive yield to be the driver of performance going forward.
The local EM rates story is increasingly appealing but is likely to come under pressure as the Fed starts to normalise rates.
However, with much cheaper currencies and high nominal yields we believe that EM local debt is much better positioned for the beginning of rate rises than prior to the ‘taper tantrum’ in 2013.
At the time of writing, EM local currency debt trades at spreads of approximately 4.70% over US Treasuries, at the higher end of its historical range. That said we remain selectively cautious on EM local bonds.
For example, we are negative on Poland and South Africa due to the potential upward pressure on inflation expectations from their weaker currencies.
Our views continue to reflect a relatively cautious stance on EM currencies versus the US dollar.
As explained last month, the Fed’s normalisation of interest rates is likely to be accompanied by higher volatility as investors repatriate capital from higher yielding currencies.
In our view, the EM currencies most sensitive to this risk are the:
- South African rand
- Turkish lira
- Brazilian real
We are particularly negative on the South African rand, which was downgraded this month to a single negative by our currency risk premia group, and is reinforced by the double negative view on South African local currency bonds taken by our duration risk premia group.
We have become more positive on the Turkish lira given our belief that the negative newsflow is starting to be priced in, but we note the potential for volatility around the upcoming elections.
We also remain negative on Asian currencies, such as the Singapore dollar and Korean won, due to deflationary pressures across the region.
Given the wide dispersion in growth and inflation dynamics across the EM universe, it is important to consider EM from both bottom-up and top-down perspectives.
As the Fed begins to raise interest rates, we expect higher quality countries to outperform the broader emerging market universe, which may come under considerable stress across a number of risk premia.
Our risk premia research groups remain focused on EM assets and their role in our portfolios.