By the end of 2017, emerging market (EM) assets were on track to deliver their best performance since 2009. An environment of improved global economic growth, higher commodity prices, and still-easy liquidity conditions has driven a rally across asset classes, enhanced by a weaker US dollar. As of mid-December, total returns on EM equities were over 30 percent in US dollar terms, currencies and local-currency bonds over 10 percent, and US dollar bonds just under 10 percent.
Looking to the year ahead, we expect these benign global drivers to remain in place, complemented by favorable conditions domestically. On average, we expect emerging economies to grow at a faster pace than the 5 percent clip we estimate for this year. In line with the economy, corporate profits are in the early stages of growth, while business sentiment is upbeat. And through prudent policymaking, external balances are strong and real interest rates are higher than in other regions.
With this outlook, we have dialed up our pro-risk stance in our global asset allocation through an overweight in EM local-currency bonds, favoring them over US dollar high-grade bonds. This position complements our tactical allocation within emerging markets, where we increased our overweight to equities and maintained our overweight to US dollar high-yield sovereign bonds.
Our view on local-currency bonds reflects our faith in EM currencies and monetary policy. First, we believe these currencies could gain further against the US dollar. On one hand, emerging economies’ prospects remain solid in our view – with even higher growth rates compared to developed economies – while their current-account balances are stronger than they have been in years.
On the other, we see a softer US dollar regime as the Federal Reserve only gradually raises interest rates. And while the US tax reform may boost sentiment on the greenback initially, we expect its weakening trend to resume not long after.
Second, EM monetary policy still has an easing bias, and further rate cuts are likely in some economies amid subdued inflation. This should contain upward pressure on local-currency bond yields in an environment of gradually rising yields in advanced economies. All told, we think a diversified selection of local-currency EM bonds offers an attractive interest rate carry of 3.6 percentage points against US government bonds, and 2.1 points against investment grade US dollar EM sovereign bonds.
Our increased equity position reflects our confidence in corporate profits. To be sure, company earnings have been robust, and we credit them for much of the 30 percent rally in MSCI EM this year. But valuations are still relatively attractive, and the 11.5 percent return on equity still lags the pre-crisis average of 15 percent.
Given our view that emerging economies and earnings are still early in the growth cycle, we think there is further room to advance, albeit more subdued. We expect 8-12 percent return on EM equities next year.
What could go wrong? Faster-than-expected monetary tightening in advanced economies is a key risk, especially if it leads to a sharp increase in the US dollar. In China, policymakers are fine-tuning growth while deleveraging at the same time, but could make a poor calculation. Geopolitics and local idiosyncratic factors, such as elections in Mexico and Brazil, will need monitoring.
Soft commodity prices, a NAFTA deal breakdown, and a weakening in global activity could also hurt our risk-on stance. But barring major shocks, we believe EM assets have the potential to deliver solid, attractive returns in 2018.
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