Emerging Markets Opportunities still exist

We believe emerging markets continue to offer attractive investment opportunities even after a strong 2017. Many of these markets are enjoying ongoing progress of meaningful economic and political reforms, as well as improved current account balances and lower inflation.

Opportunities still exist, despite recent strength

By Gonzalo Pángaro and Samy Muaddi

Key points

Emerging markets (EM) equities still appear cheaper than developed markets and versus their own historical levels, although they are more expensive than a year ago.
Although yields on EM bonds have fallen (and prices have risen), the asset class offers broadly healthy relative fundamentals and attractive yields.
Risks include a sharp China slowdown, a Korean conflict, the withdrawal of quantitative easing, or a commodity price collapse.
Active management lets equity investors focus on attractive pockets of EM growth and allows bond investors to own assets outside their benchmark.

We believe global emerging markets (EMs) continue to offer attractive investment opportunities even after a strong 2017. Many of these markets are enjoying ongoing progress of meaningful economic and political reforms, as well as improved current account balances and lower inflation. Emerging market growth looks set to continueBroadly speaking, economic growth in EMs outpaced developed markets’ growth in 2017. This stronger growth should continue in 2018 as countries like Brazil, Russia and India improve. Growth should support further gains in corporate earnings, which recovered strongly in 2017. Furthermore, we continue to see many companies undertake steps to control costs and improve profits.Equites still look attractiveEM equity valuations, as measured by price-to-earnings ratios, appear competitive versus developed markets and their own historical levels, although they are more expensive than a year ago (see chart).

Asia reforms, while emerging Europe lagsAsian countries, notably India and Indonesia, are enacting much-needed reforms and correcting the fundamental imbalances that made them vulnerable in past financial crises. Strong capital flows and muted inflation have improved their current account balances, which should support more sustainable growth. Stable growth in China has helped support emerging economies, particularly in Asian countries linked to China’s supply chain. Although Chinese growth could moderate as the country’s government focuses on quality of life for its citizens while also reforming its legacy industries and reducing debt, we would expect any slowdown to be modest.

Emerging European countries, particularly Russia and Turkey, have made less progress than other regions. However, Russia grew strongly in 2017 driven by domestic demand. Russia’s inflation remains moderate, so its central bank has room to cut rates, which could boost growth and support both bonds and equities. Latin American political trends offer opportunitiesDespite probable short-term volatility, we see attractive longer-term prospects in some Latin American countries. Market-friendly political measures are being implemented in countries formerly led by populists. For example, Argentine President Mauricio Macri, elected in 2015, has made significant progress on meaningful reforms and looks likely to win re-election in 2019. Likewise, Brazilian markets have rallied impressively amid optimism that Michel Temer, who took office in late 2016, will successfully implement structural reforms. Brazil’s economy is showing signs of finally recovering from its deep recession. However, Mexico faces the risk of the US renegotiating the North American Free Trade Agreement and a potential victory for leftist presidential candidate Andrés Manuel López Obrador in 2018. EMs now more resilient, but external risks remainAn unexpected acceleration in monetary policy tightening in developed markets could spark market volatility. Nevertheless, we believe EMs are relatively well positioned to maintain stability in an environment of gradually higher interest rates, primarily due to healthier current account balances and more prudent government spending. Also, interest rates in EMs remain relatively high, giving their central banks the flexibility to lower rates if needed.While a fall in commodity prices could weigh on some assets, EMs are more broadly balanced between commodity-importing countries and commodity-exporting nations than previously. Concerns about the Chinese economy have eased; we continue to monitor its transition to a consumption-based economy, with a particular focus on the health of the financial system.Bond market buying opportunitiesCorrections in EM bonds sparked by external events such as North Korean geopolitical tension, developed market political instability or US protectionist policies could offer buying opportunities. As of late 2017, we preferred local currency EM debt over US dollar-denominated bonds, as some major local currencies appeared poised to gain against the US dollar.Equities diverging, requiring in-depth analysisWe believe the future path for EM equities is likely to be less homogenous and more divergent than it was in an era when commodity prices were rising, global trade was strong and China’s economy was growing at over 10% annually. This suggests that rigorous analysis of company fundamentals will be more important than ever in 2018. Being proactive will be essential to identify and invest in the most attractive opportunities within these highly diversified markets.Active management in emerging marketsIndividual frontier markets bonds appear to offer compelling investment opportunities for active managers. We believe the ability of active managers to invest in specific countries not included in the standard EM benchmarks offers an advantage.
Active management of EM bonds also provides the ability to overweight countries, such as Brazil, that are easing monetary policy and to make country allocations based on fundamentals rather than the amount of outstanding debt.

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