A ray of optimism peeked through at the annual International Monetary Fund/World Bank Group meetings: The outlook for emerging markets (EM) is decidedly constructive.
The vortex of the taper tantrum, lower commodity prices and China volatility that clouded the EM outlook from 2013 through 2015 appears to be in the rearview mirror. The macro environment has stabilized, political frameworks are mostly moving toward orthodoxy and concerns that EM could “contaminate” developed market (DM) economies seem to have receded. And for investors, the outlook is cautiously optimistic as EM valuations remain inexpensive compared to those in DM, providing upside potential for both hard and local currency assets.
The improvement in the prospects for EM and the lack of higher-yielding alternatives have boosted investment flows to the asset class by $51 billion so far this year, and inflows are expected to continue, absent any global shocks. Institutional and retail investors are returning to EM for its diverging narratives – for example, the recovery in EM versus the uncertainty in Europe.
Indeed, the expanding scale and scope of EM investors at the IMF meetings in early October was apparent, highlighting the continued maturing of the asset class. Investors ranged from traditional EM dedicated investors and local asset managers to sovereign wealth funds, reserve managers, banks and global macro funds, all contributing to a fuller discourse.
Risks to emerging markets shift
The consensus at the IMF meetings was that headwinds for EM appear to be largely contained. The Federal Reserve’s gradual rate-hike cycle and talk (just talk) of tapering from the European Central Bank aren’t likely to cloud the EM outlook. While European growth, politics and banks remain concerns, the fallout for EM should be limited. A Trump presidency in the U.S. perhaps poses the greatest near-term challenge, particularly for Mexico and China, but even here, constraints on presidential power should limit potential damage. Overall, this rather sanguine view suggests risks to EM are likely to come from a repricing of the U.S. term premium or negative surprises on global central bank policy.
The hard-versus-soft-landing in China discussion was replaced by the hard-versus-soft-Brexit debate, suggesting fewer systemic consequences for EM. In fact, China fears barely surfaced at the recent meetings, and it seems likely that the financial markets will sweep bad news under the rug at least until the next Communist Party Congress in autumn 2017. The positive sentiment on China notwithstanding, PIMCO remains vigilant to risks surrounding property markets and continues to concentrate on-the-ground monitoring efforts here.
Numerous EM central banks have room to cut rates, but policymakers seemed keen to maintain credibility and await progress on the fiscal front. With disinflation likely to continue due to base effects, lower food prices and stronger exchange rates, the extent of potential cutting cycles – in Brazil and Colombia, for example – depends on fiscal developments. The higher likelihood of easing monetary policy, fiscal effort and stronger EM currencies points to steeper yield curves and compression in EM yields.
Divergence within the asset class continues. Credit rating downgrade pressures are greatest in Turkey and South Africa. Meanwhile, Latin America remains the current favorite: More than half of investors surveyed by J.P. Morgan around the time of the IMF meetings expressed the desire to increase exposure to the region. That suggests the potential for a further rally in Brazilian assets, an eventual end to the protracted weakness in the Mexican peso and further upside in Argentina. Venezuela remains the main default candidate within EM, but contagion should be limited.
Long-term outlook for emerging markets
The longer-term outlook for EM hinges on structural reforms, a recurring topic at the IMF meetings. With low growth in DM, reduced global trade and the prospect of increasing protectionism, potential growth across EM is much lower now than before the financial crisis.
Policymakers in Brazil and some other countries view confidence as the key to unlocking economic growth in the very near term. Longer term, EM policymakers are starting to recognize the need for supply-side reforms that target fiscal efficacy, infrastructure investment, labor market inefficiencies and lowering the cost of doing business.
Lupin Rahman is global head of sovereign credit, and Yacov Arnopolin is an emerging markets portfolio manager.