After their stellar performance last year, emerging market assets have taken a back seat, and most have been in the red since the beginning of April.
This is when the risk that had largely been at the back of investors’ minds – a faster pace of interest rate hikes by the Federal Reserve – came to the fore.
The uneasiness reached its peak after the closely watched yield on 10-year US Treasury bonds surpassed 3 percent for the first time in three years. To many investors in emerging markets, the key question now is whether the game is over, or whether they should be adding exposure given the recent correction.
It’s important to put things in context. First, the lower levels of liquidity, as evidenced by higher costs of borrowing and a strong US dollar, are creating headwinds for all risk assets across the globe.
Although positive, the returns on US and European equities since April have been less than 3 percent. And save for the 10-year Treasury and select high-yield bonds, total returns on most major credit indexes have been negative.
Second, as Warren Buffett said, “when the tide is low, you can see who is swimming naked”. This is a metaphor for the fact that when liquidity recedes, the market becomes more choosy, thus exposing those assets that are most vulnerable.
By geographic classification, these are by definition the emerging market assets; and within emerging markets, the most affected have been those with problematic deficits and inflation, such as Turkey and Argentina.
Third, concerns about global monetary policy and countries’ structural balances have been supplemented by noise of the political kind.
On one hand, the threats of protectionism and geopolitical tensions in the Middle East and Eastern Europe have played into investors’ bias toward a “risk-off” mentality.
On the other, the uncertainty of political transitions in emerging markets – as proven last week by the victory of the opposition in Malaysia’s general elections – adds to anxious investors’ reasons to stay on the sidelines.
But for all the headline noise, we must keep a keen eye on the fundamentals. The twin fiscal and current account deficits in the United States, along with the absence of convincing evidence that they can be reversed, suggest that fears of a stronger-than-expected surge in US rates and the US dollar are overdone.
To be sure, the Fed will continue to raise rates, and so eventually will its counterparts in the eurozone and Japan. But with their inflation subdued, advanced economies are far from overheating, and we remain convinced that these central banks will pace their rate hikes gradually.
At the same time, the recovery in emerging economies remains intact. Although the momentum has slowed in some countries, their overall growth this year is still set to outpace last year’s, and thus maintain their advantage relative to developed countries’ GDP growth.
Inflation in these markets also remains muted. Furthermore, most emerging market policymakers have the fiscal or monetary latitude to implement countercyclical measures, if needed.
Putting all these together and taking into account the more attractive levels of valuation following their recent correction, we are more inclined to buy rather than sell emerging-market assets.
While the game has become more uneasy – we have been emphasizing that the period of extraordinarily calm markets is over – the fundamental positions of the players have not changed, and we recommend staying invested while actively managing the risks.
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