Emerging MarketsFeb 14 2018

Economics aiding emerging market debt

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Economics aiding emerging market debt

Volatility was meagre, global growth was present, inflation failed to pick up to a damaging level, and all this supported emerging markets (EM) in continuing on a strong trajectory. We do not expect things to be too different this year.

Global growth is still strong and shows no signs of abating, with economic data continuing to improve across all markets. Our own proprietary economic health indicator shows the the four largest economies re-approaching pre-crisis levels.

As a result, we raised the probability markets will price in above-trend growth from 65 per cent to 70 per cent, and, at the same time reduced the near-term probability of recession to zero (from 5 per cent). This recognises that the flattening yield curve continues to be a function of low inflation and continued global quantitative easing, not recession.

But as the global central banks gradually take a step back from monetary easing policies and the Federal Reserve starts to unwind its balance sheet at a faster pace, financial conditions will tighten - thankfully not to levels that would lead to an EM sell-off.

But, investors will need to remain flexible when the investment environment changes, and having an overall flexible fixed income approach can help insulate investors. This may include considering exposure to selective sectors in EMD like local currency debt, and high-yield sovereign and corporate bonds which offer the best exposure to the economic backdrop, while providing attractive valuations.

The good news is that growth is expected to remain a positive driver behind the investment case for this asset class. Major EM countries such as Brazil, Russia and South Africa are finally recovering from severe recessions in 2015-2016 and as a result total EM growth is not only forecast to increase, but should been seen more evenly across a greater number of regions.

Importantly, while developed market growth troughed later in 2012, emerging markets continued to slow for another three years and only started to turn around in 2016. As a consequence, developed markets are entering late stages of the economic cycle, whereas emerging markets are still in mid-cycle stage. This year, EM GDP growth is expected to accelerate to 4.9 per cent while developed market GDP growth is forecast to stall at 2.3 per cent.

Buyers beware

But let us not be complacent. There are challenges investors need to be wary of. Higher inflation is on the cards for most EM countries which could cause pressures, most notably in China, India and central eastern Europe. Across emerging markets, it is likely to rise from 4.2 per cent year-on-year in 2017 to around 4.5 per cent in 2018.

But at the same time, economists have generally over-estimated inflation's ability to rise. And while there are strong reasons to believe that there will be global reflation, other factors should continue to moderate overall higher inflation risks.

Aside from all the mid to late cycle signs, the end of global quantitative easing policies should also play a central role. US balance sheet reduction alone should not be disruptive for markets, but when it is added to the Bank of Japan’s tweaking of the yield curve control and the European Central Bank's taper later in 2018, it could create some volatility in core markets such as South Africa, Turkey, Brazil and Argentina.

On a political course

There is no hiding from the fact that 2018 marks a full-on political calendar, which could either spur or weaken the EM improvement story.

In Brazil, the upcoming general election poses a lot of uncertainties as corruption scandals continue to hurt the current government, which provides a favourable environment for a populist politician or an outsider to step in.

The importance of this vote is amplified by the need for social security and other reforms to fix a concerning fiscal outlook and put the economy on the right growth track.

Similarly, in Mexico, upcoming presidential elections in the summer look to be favourable to populist Morena candidate Andrés Manuel López Obrador and there are additional political risks stemming from the ongoing North American Free Trade Association renegotiations.

While in South Africa, Cyril Ramaphosa’s win in the ANC elections in December was an encouraging sign for the markets, but a lot of Jacob Zuma’s loyalists remain in the ANC leadership, potentially slowing any reform momentum. In Turkey, the situation remains uncertain and is a political risk story that will most likely continue to put investors on edge in 2018.

Investors are without a doubt faced with an environment that will have shifting economic conditions over the next year.

We feel confident that the fundamentals for investing will improve in EMD. This could be joined by a backdrop of economic growth and manageable inflation levels, which should keep company earnings, and therefore debt servicing, in a positive situation. This will help investors weather any potential surprises in interest rates, geopolitics or central bank policies.

Pierre-Yves Bareau is head of emerging market debt at JPMorgan Asset Management