Why emerging markets may be the major story ahead

EMs have had a dismal three and a half years. Excessive capital inflows during the US quantitative easing period collided with the end of the US Federal Reserve’s asset-purchase programme in 2013, and were then hit by gloomy expectations of the Fed tightening monetary policy.

The oil price drop shock undermined confidence in some countries, sectors, companies and banks, especially in anything commodity-connected.

The debate about China’s hard landing, or not, allied to fears of a huge renminbi devaluation, made things worse.

Then there were worries about the world’s other massive global engine: US growth. Add to this specific risks and recession ensued in two of the so-called Brics of Brazil and Russia.

Emerging currencies are now cheap, with significant undervaluation in some cases. Philippe Ithurbide, Amundi

Emerging nations’ currencies have fallen since 2013 and expectations of world growth were revised downwards in 2014-16. So it is no surprise that capital flowed out of EMs and into advanced economies.

But take stock of where we are now.

EM debt is an oasis of yield in a desert of low/negative rates. Bond yields are negative in Japan, with the exception of the 30-year bond. Over half of all bond yields are negative or close to zero in Europe.

More than a third of the Barclays Euro Global Aggregate index – which includes sovereign, quasi-sovereign, corporate bonds and bank and financials bonds – offer negative yields, with a tiny proportion of the index yielding in excess of 2 per cent. In contrast, emerging debt still has attractive yields for investors seeking income.

Emerging currencies are now cheap, with significant undervaluation in some cases. Switching from hard currency debt to local debt makes sense for investors at present.

Emerging economies have adopted flexible exchange rates for some years.

The currency depreciation prevented severe internal devaluation (recession/depression) and supported stronger recoveries.

This is very different to past crises when currencies began to depreciate in the latter stages of the financial crisis, after economic activity collapsed.

Emerging countries’ dollar debt is much lower as a proportion of total debt than in the past, and hence appreciation of the currency is not as disruptive as it used to be.

The debt structure has changed dramatically in the past 15 years, and sensitivity to the dollar or to foreign currencies has declined.

Looking ahead, EMs can be expected to be well placed, assuming these factors also come into play:

• Fed policy remains accommodative/softer than expected;

• Fears about hard landing and devaluation of the Chinese renminbi fade;

• Oil prices and commodities prices start to recover;

• World growth does not fall further.

EMs have been overlooked in the past three and a half years. As it is often the case with neglected asset classes, investors have oversold and are now underweight, with valuations offering attractive entry points.

Investors should gradually return to EMs, while remaining selective and reactive. The region cannot be considered as a bloc, and some countries still bear specific risks.

Philippe Ithurbide is global head of research at Amundi