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Emerging markets - the worst of times, the best of times

EM economies, especially in Asia, are vulnerable to the backlash against globalisation in the ‘West’ if it results in shrinking global supply chains and trade.

  • Fundamental underpinning of EM growth and investment outperformance over the medium-term remains intact
  • EM assets attractively valued versus developed market counterparts
  • Diverse universe of country and idiosyncratic risks that offer opportunities for credit pickers

Moreover, the resilience of EM policy frameworks and balance sheets have been challenged for some countries left exposed by the ‘triple whammy’ of rising US interest rates,a strengthening US dollar and the impact of QT on capital inflows. But EM assets have re-priced to reflect these risks much more than in developed markets, while the fundamental underpinning of EM growth and investment outperformance over the medium-term remains intact.

EMs benefit from a growing and increasingly affluent population; technological and productivity catch-up; the broadening of trade flows between regional markets; and the greater depth and sophistication of domestic financial markets.

Playing the EM trade

 

EM GROWTH ADVANTAGE OVER DM FORECAST TO INCREASE

Source: International Monetary Fund World Economic Outlook forecasts, October 2018

 

“The rising share of EM in the global economy and financial assets is a secular trend that investors should not ignore.”

 

The challenge for investors is accessing the return and diversification benefits from EM assets in a manner that limits the periodic drawdowns and volatility associated with the asset class.

Too few so-called ‘global strategies’ genuinely integrate the investment opportunities in EM into the investment process.The differentiation (and diversification benefits) across EM in terms of economic and political fundamentals is much greater than in developed markets.

In our view, strategies that are nimble and able to position on the short as well as long side and are less constrained by benchmarks (even China, the world’s third-largest bond market is not yet represented in all major fixed-income indices) in their investment process are best placed to exploit the opportunities offered by EM.

Credit pickers' delight

In the near-term, the growth outlook for EM remains positive and default rates are expected to remain low.

Tighter external financing conditions are a headwind, but growth in Latin America is set to accelerate (led by Brazil).Moreover, African and Middle Eastern economies are still benefiting from a modest recovery, while Asia is forecast to expand at around 6%. Credit valuations are attractive relative to similarly rated developed market credits and ‘credit pickers’can fish in a much deeper pool of distressed and performing assets that potentially offer significant capital appreciation, as well as low correlation with US rates and the US dollar.

EM currencies are in aggregate 'cheap' by historic standards although in the near-term much will depend on the evolution of the US dollar.