Since the start of the year, global growth has been slowing, yet emerging markets (EM) have performed in line with developed markets. While this may seem counterintuitive, I believe the reasons why are fairly clear:
- Fundamentals in many developing countries are improving
- Valuations are generally attractive
- Benign US monetary policy is supportive of EM assets, particularly debt
In my 2019 Multi-Asset Outlook, I raised my view on EM debt from moderately bearish to neutral. I believe that the outlook for EM assets has improved and that investors should consider raising their EM debt exposure.
Improving fundamentals thanks to currency weakness
Two of the biggest challenges for emerging markets in 2018 were higher US interest rates and a stronger dollar. Tighter liquidity conditions caused EM currencies to depreciate and helped trigger the collapse of the Argentine peso and Turkish lira midyear. In both countries, large current account deficits, heavy US-dollar-denominated debt burdens, and high inflation were contributing factors.
Once the crisis spread, EM currencies broadly fell by 10% to 50%. This depreciation helped start the fundamental recovery process by allowing economies to improve their trade balance (through cheaper exports) and battle inflation (via central bank hikes). Turkey in particular has been a standout, shrinking its 8% current account deficit to zero in a matter of months.
Attractive debt valuations
EM debt valuations are attractive. As FIGURE 1 shows, local EM debt markets have recently provided almost six percentage points more yield relative to developed market (DM) sovereign bonds. The difference is also above the median of the historical range.
EM local yields are attractive relative to DM sovereigns
Sources: Bloomberg, Wellington Management; As of 12/31/18 |EM government bond yield are proxied by JPMorgan Global Bond-EM Index. This index is a comprehensive EM debt benchmark that tracks local currency bonds issued by EM governments. DM government bond yield are proxied by the average of five-year government bond yields of the US, Europe, and Japan. Past performance is not a guarantee of future results. Indices are unmanaged and not available for direct investment.
Benign US monetary policy
US monetary policy has become more supportive of EM debt and equities. Since its January meeting, the US Federal Reserve has repeatedly indicated that it has paused rate hikes amid uncertain global conditions and low, stable inflation. These signals suggest a period of low interest rates and limited US dollar appreciation, both of which are typically tailwinds for EM assets. Risks do remain: Any combination of intensifying trade protectionism, tighter-than-expected US monetary policy, or a more severe global growth slowdown could cloud the picture for EM debt markets.
EM debt may be more attractive than EM equities. EM equity benchmarks are largely concentrated in Asia, where the global slowdown has more severe consequences.
US-dollar-denominated EM debt markets may be attractive for investors who prefer to avoid currency risk.
Country differentiation is key: Countries with relatively high yields and stable or falling policy rates include Russia and Mexico. Country-specific risks, in the form of election uncertainty or political scandals, for example, are also important to monitor.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets or in a particular geographic region or country.
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.