The New Case for Emerging Markets
It’s still not too late for investors to invest in emerging markets.
With emerging markets (EM) having made huge gains year to date, asset owners may be wondering if it’s too late to invest. I don’t believe it is. Several new developments fortify the case for emerging markets and suggest, in my view, that both EM equities and debt have more room to run. Asset owners may be familiar with the structural case for EM: stronger domestic growth, rising consumption from a growing middle class, and greater adoption of sound fiscal and monetary policies. In addition, recent developments suggest the potential for further outperformance:
• China’s stabilized growth
• Benign outlook for US dollar and interest rates
• Cheap valuations relative to developed markets
China’s growth has stabilized
The outlook for emerging markets hinges on China, the world’s second-largest economy. Recent fears that China’s growth would contract to 5% or less appear to be overblown. While it has slowed from the double-digit pace of the late ‘90s and early 2000s, China expanded by 6.9% in the first two quarters of 2017, thanks largely to the all-important property sector.
The resilience of the Chinese property market has surprised many. Interest rates have risen, which would typically tighten credit and slow property sales. However, it seems that the government is implementing a two-tiered rate policy, applying higher rates to financial institutions and lower rates for the rest of the economy. The approach appears to be working: Bank credit growth is slowing and record-low mortgage rates support strong consumer sentiment (Figure 1).
I am less concerned about high corporate debt levels relative to GDP.1 The Chinese government is addressing this problem and most of the bad corporate debt is owned by state-owned banks, reducing the risk of corporate failure, which could trigger systemic problems. Finally, it seems likely that, given the leadership transition later this year, the government will work to keep the economy humming along in the
Low mortgage rates are still supporting China’s property market, despite higher short-term rates
Outlook for the US dollar and rates is benign
My view that US interest rates will rise substantially has moderated, as the primary impetus—President Trump’s ambitious fiscal agenda—has weakened. That said, I still think interest rates can move somewhat higher given that the US Federal Reserve (Fed) is more confident in the economic outlook and seems determined to normalize rates. A more benign rate outlook also caps the upside for the dollar. Emerging markets have historically been sensitive to changes in the US dollar and interest rates; a strong dollar and/or higher rates tend to draw capital away from EMs, in favor of the US.
Trump may establish a protectionist stance against EM countries, but I think the risks of this are lower than they were a few months ago. The Mexican peso is the best-performing currency this year, reflecting a lower probability that the North American Free Trade Agreement (NAFTA) will be terminated. In addition, Trump has stepped back from his tough trade rhetoric with China, although tensions with China over its handling of North Korea’s nuclear program could reignite trade risks.
Valuations are attractive
Using various metrics, EM equities and debt look attractive relative to developed markets (DM). Figure 2 shows that over the past 10-year period, EM equities have been cheaper than the US, Japan, or Europe just 27% of the time when measured by the Shiller price-to-earnings (P/E)3 metric. While not as dramatic as the Shiller P/E, EM’s price-to-book (P/B)4 ratio looks attractive relative to developed markets as well.
EM equities are cheaper than developed markets
Sources: IBES, Datastream, Wellington Management
EM local debt is also attractive. Local yields, which have come down since their peak in 2015, are still much higher than developed market government bond yields (Figure 3), and they could fall further if EM central banks reduce short-term rates amid lower inflation. Bond prices rise as yields fall, so EM local debt appears to have plenty of room to appreciate from here.
Investors should also consider evaluating local currencies, which are the biggest source of volatility in local EM debt. Today, while EM currencies have appreciated significantly relative to their 10% to 50% plunge between 2013 and 2016, they still have substantial upside in my view.
EM government bonds offer attractive yields
Note: Developed Market Treasury yield proxy is Bloomberg Barclays Global Treasury yield to worst. Yield to Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.Emerging Market Government Bond Yield proxy is JPMorgan Emerging Market Bond Index plus diversified blended yield. | Source: Bloomberg. Past performance is no guarantee of future results. The performance shown is above is index performance Indices are unmanaged and not available for direct investment. For illustrative purposes only.
Consider adding to EM. Given the healthy global backdrop, recent supportive developments in China, a more moderate view of US rates and the dollar, and cheap relative valuations, EM is attractive. EM equities and local debt both can offer potential upside from current levels, with debt being less volatile.
Consider favoring active over passive management. EMs have historically had much wider return dispersion than DMs. From 1995 to 2016, the median range of returns across EM countries was nearly twice that of developed countries, meaning the difference between the lowest and highest returns was almost twice that in DMs.5 Wide dispersion of EM returns gives active managers more potential to identify investment opportunities that can outperform the benchmark.
Be aware of country differentiation.
China — Growth is still strong relative to developed countries, and the government is seeking to establish stability in the financial sector. I favor consumer-oriented sectors such as healthcare and consumer discretionary. Technology and financials also appear to have upside.
India — President Narendra Modi is implementing bold policies, including demonetization and tax reforms aimed at bringing the underground economy into the formal economy, broadening the tax base, streamlining the tax system, and removing the burdensome tax on the interstate movement of goods.
Russia — Low oil prices are problematic for this oil producer; however, the government’s budget already discounts oil at $40 a barrel. Should the price of oil drop below this level, a weaker ruble would likely help stabilize the economy. Inflation has also fallen from double digits to 4%, leaving room for Russia’s central bank to lower interest rates further.
Turkey and South Africa — Because these countries run large current account deficits, they are dependent on foreign financing and could face a liquidity squeeze if investor sentiment sours.
About the Author:
Nanette Abuhoff Jacobson is managing director and multi-asset strategist at Wellington Management Company LLP and global investment strategist for Hartford Funds.
With more than 25 years of experience in the capital markets, Nanette has held a variety of roles spanning the major asset classes. As the global investment strategist, she analyzes and interprets markets and investment opportunities for those mutual funds that are sub-advised by Wellington Management Company LLP, and shares those views with Hartford Funds’ sales organization, the financial advisor community, and major broker-dealers and distributors. She also advises Wellington Management's institutional clients, including pension funds, insurance companies, endowments and foundations, and central banks, consulting on strategic asset allocation issues to develop multi-asset investment solutions.
1Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
2The Shanghai Interbank Offered Rate (SHIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the Shanghai wholesale money market.
3Shiller price-to-earnings is the ratio of current price to prior 10-year inflation- adjusted earnings.
4Price-to-book is the ratio of current price to prior 12-month book value.
5Source: Wellington Management, 8/17
All investments are subject to risk, including the possible loss of principal. Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. Foreign investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions. These risks are generally greater for investments in emerging markets.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.