Emerging markets: Poised for a rally?
Our latest Global Market Outlook quarterly update continues to provide relevant guidance on where to consider investing. One area of focus is the state of emerging markets (EM), which have been in the doldrums for several years. Now, we’re starting to see improvement in their potential and think they may be poised for growth in the next 12 months.
At Russell Investments, we evaluate economic growth using a CVS (Cycle, Valuation, and Sentiment) model. Within EM, the first recent steps towards improvement began with the “V”. We have seen relatively compelling absolute and relative valuations1 but have been concerned about the cycle.
When we refer to cycle, that means we’re looking at factors such as political events, economic underpinnings and the earnings outlook. Over the course of this year, while all is not rosy, we do think the cycle is changing tack, things are still bad, but slowly becoming more positive. And as the cycle improves with corresponding compelling valuations, we believe sentiment is likely to get less negative for the asset class.
With these factors in mind, I agree with our strategists that EM can be a good value. U.S. assets are expensive, particularly those such as U.S. government bonds and defensive large-cap stocks. As noted in this most recent Global Market Outlook, European and Japanese assets are somewhat less expensive, but their risks and values are not as compelling as EM.
Looking through a multi-asset lens
Sitting on the multi-asset team gives me a unique perspective. I have the advantage of looking across opportunity spectrum rather than within a single asset class. For example, a fixed income portfolio manager might have to choose between investing in hard currency or local currency emerging market debt (EMD), while equity portfolio managers focus on the stock market. Our team can look at EM with multiple lenses including currencies, rates, corporate credit, and equities.
In many multi-asset portfolios, one might have chosen to start off with increased exposure to local EM currencies which have rebounded quite nicely over the past seven months as measured by the MSCI Emerging Markets Currency Index2. Let’s get geeky for a moment. Typically cycle improvement begins in EM with pain in the form of rapid currency depreciation followed by rate hikes to quell inflation. These actions often cause a swift economic slowdown. Most of these milestones have largely already occurred in EM and many central banks, like Russia's, have now begun to cut rates again.
Such currency depreciation usually steadies at lower levels eventually, which can then help to improve export growth. This is now happening in EM and typically helps to improve earnings and equity markets recover. In short, such cycle improvement typically begins with currency, followed by rates and eventually equities3.
Admittedly, problems for some EM countries are not small and investments in these markets are far from safe. Brazil, for instance, has been wracked by recent political turmoil and a downturn in commodity prices, like oil4. However, investment opportunities have been opening as the cycle has been improving. The political climate is starting show signs of improvement with Dilma Rousseff’s impeachment on August 31, yet it’s also true that the rally thus far has decreased valuation differentials5. We are getting closer to the ‘show me’ stage where investors will need to see further fundamental improvement.
Of course, this is just one example among the many EM opportunities that our team is considering for some of its multi-asset portfolios. Right now, for most multi-asset investors, I believe in being overweight in EMD (local-denominated) and, to a lesser extent, equity, while less sanguine on hard currency in EMD.
Emerging markets and rising interest rates
Looking forward, many people are concerned about likely rising rates in the U.S. and its potential impact on EM. While we did see that play out during the “taper tantrum” in 20136, our team believes that the painful adjustments in EM since then have put them on firmer footing for upcoming slow rate rises. For instance, real rate differentials are 3x more favourable towards EM today vs. the US compared with 20137, a nice cushion! Of course, as with any investment, there are real risks but overall I expect less negative impact as fundamentals improve compared to past points in the cycle.
In today’s low-return, highly volatile investment environment, multi-asset investments, due to their diversified nature, have the potential of finding opportunity for value while managing for risk. So keep your eye on EM and other potential sectors for opportunity. You know we will.
2 The MSCI Emerging Markets (EM) Currency Index will track the performance of twenty-five emerging-market currencies relative to the US Dollar. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
3 Principles of Economics. N. Gregory Mankiw. 6th Edition. February 2011.
4 WTI Crude as of September 30, 2016
5 Purchasing Power Parity for currency, real rate differentials for rates, price to normalised earnings for equity. Purchasing power parity (PPP) is a theory in economics that approximates the total adjustment that must be made on the currency exchange rate between countries that allows the exchange to be equal to the purchasing power of each country’s currency.
6 Taper tantrum is the term used to refer to the 2013 surge in U.S. Treasury yields, which resulted from the Federal Reserve's use of tapering to gradually reduce the amount of money it was feeding into the economy. The taper tantrum ensued when investors panicked in reaction to news of this tapering and drew their money rapidly out of the bond market, which drastically increased bond yields. Source: Investopedia.
7 Morgan Stanley Research. September 14, 2016.