Asset Allocation View: Are Emerging Markets Turning the Corner?

Asset Allocation View: Are Emerging Markets Turning the Corner?

The landscape in emerging markets (EM) has been steadily improving over the last few months. Commodity prices are tentatively hitting a bottom, China’s economic transition is proceeding well and the Federal Reserve has tempered its plan to raise interest rates, and with that, the strength of the U.S. dollar.

With this in mind, we are beginning to redeploy capital to EM where we can find good value.

What we’re seeing:

  • Equities: The dramatic negative momentum of earnings should soon end as commodity prices stop falling and purchasing managers indexes rise. Based on the MSCI EM and ACWI indexes, trailing price-to-earnings multiples for EM are at a 25% discount to developed markets, dividend yields are slightly higher, and while return-on-equity is similar, EM offers significantly higher free cash flow yields (8% versus 6%). So we think equities are a great way to get selective EM exposure.
  • Currencies: We like a number of markedly depreciated currencies that offer yields rivaling high yield debt but with much more liquidity and far less risk of sharp price swings. These include the Mexican peso and Russian ruble.
  • Rates: A number of yield curves, including those in Mexico and South Africa, are particularly attractive as we believe investors have priced in too many interest rate hikes.

Putting EM in context

From a portfolio perspective, there has been little incentive to venture out of developed markets in recent years. Across equities and fixed income, the developed markets have enjoyed outsized returns for the past five years, supported by ever lower interest rates and central banks’ quantitative easing policies. Emerging market assets, meanwhile, have lagged as growth rates – and commodity prices – fell dramatically, and, more recently, the Federal Reserve moved toward normalizing interest rates in the U.S.

Now, however, valuations in the developed markets fully reflect the benefits of a lower discount factor. The tailwinds of accommodative central bank policies are fading and may even be disappearing: We have reached the watershed of negative interest rates in many countries and wonder if they are helpful at all, as they are accompanied by tighter financial conditions.

Just as these tailwinds abate, the outlook for emerging markets is improving. Of course, some risks remain. While the C’s (China, central banks and commodities) are calmer, we will have to watch for potential storms, including faster-than-expected depreciation in the yuan or another sudden fall in oil prices.

Earlier in the year, we were cautious toward emerging markets but kept an open mind. Now we think the time has come to actively engage.

DISCLOSURES

All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.