Attraction of Emerging Markets
- We believe conditions look favorable for continued positive performance across EM debt and equity markets in 2017
- The low but positive economic growth backdrop is a supportive one for emerging market countries to continue improving their balance sheets
- EM corporate earnings may experience a tailwind from improving productivity relative to real wage growth
Following several years of underperformance relative to developed markets, emerging market assets staged a comeback in 2016 across both debt and equity markets. We believe conditions look favorable for this trend to continue in 2017.
The global macroeconomic backdrop is supportive, with low but positive economic growth combined with tame inflation by historical standards. While interest rates look set to move higher in the U.S., we believe that emerging markets are broadly equipped to handle this.
Prospects vary from country to country, but emerging market countries have generally improved their balance sheets in the wake of the financial crisis of ‘08/’09. Growth has been slower in some regions but many countries have deleveraged and funding sources look more than sufficient to cover financing needs.
On the fixed income side, opportunities exist across both EM sovereign and local debt as well as EM corporate debt. Local debt markets, after recovering in 2016 following three years of underperformance, may benefit from currency valuations that appear cheap by historical standards. Similarly, EM corporate debt issues generally look cheap versus their developed market counterparts, with lower duration risk in many cases.
"The global macroeconomic backdrop is supportive, with low but positive economic growth combined with tame inflation by historical standards."
On the EM equity side, there are grounds for optimism when it comes to what we view as the most important driver of performance—corporate earnings. Productivity growth is now exceeding real wage growth, a trend that looks set to continue after years of capex investment. Absolute and relative valuations, particularly cyclically adjusted price-to-earnings ratios, appear attractive by historical standards. Emerging markets earnings forecasts are also generally less efficient than developed equities as fewer sell-side analysts are following the companies, leading to potential opportunities for active investors.
Of course, emerging markets are not without risks. Near the top of this list heading into 2017 is trade, given the heavy reliance of many emerging economies on exports. We’ll be closely monitoring this in 2017 as trade agreements and alliances such as the TPP may fall victim to the global trend toward nationalism. A weaker-than-expected Chinese economy and/or faster-than-expected U.S. Fed rate hikes also pose risks, making country and security selection that much more important. In general, we see risks as being idiosyncratic by country and security rather than systematic.
In summary, conditions look reasonably supportive for emerging markets heading into 2017 but there are enough risks on the horizon that it may be a volatile ride.