After a strong run in emerging markets through the first nine months of 2017, a recent performance setback in local bond markets has led some investors to fear that the recovery cycle may be short-circuiting. Is the two-month run of underperformance in EM local markets an opportunity or a canary in a coal mine?
Heading into 2018, we are inclined to view sell-offs like the recent one as an opportunity rather than an alarm bell. This is based on a few key premises:
- EM growth and asset performance are first and foremost functions of global growth. Global GDP growth has strengthened and broadened in 2017, so the backdrop for emerging markets is strong heading into 2018.
- EM asset performance is also determined by global liquidity conditions, which are now at their most robust since the global financial crisis. In addition, financial leverage remains low thanks to post-crisis constraints on bank capital.
- The gradual removal of extraordinary central bank accommodation should not undermine EM performance as long as central banks continue to strike a balance between financial stability and growth/inflation objectives, which could in turn extend the business cycle. EM performance is usually derailed not by cyclically driven increases in nominal interest rates but rather by sharp changes in asset prices that undermine growth. Importantly, asset price shocks do not necessarily involve a jump in real interest rates; they can be the products of a more gradual withdrawal of liquidity that tips over inflated asset markets, as was the case with the tech bubble in 2000 and the real estate bubble in 2008.
- The lack of major imbalances in most EM economies suggests that an unexpected interest rate shock to the global economy would not have the deleterious consequences seen in 2013 (the “taper tantrum”). It will be important to watch whether imbalances build as financial conditions remain robust and if so, where.
Strong fundamentals help insulate EM
Emerging markets remain high-beta “condition takers” through both trade and capital flows. But the key difference today is that emerging economies do not have the cyclical imbalances that typically exacerbated shocks in the past. EM has arguably never been as well-insulated in fundamental terms during the mature stage of a U.S. rate-hiking cycle.
Political risks still matter for EM, but even so, the lack of cyclical imbalances helps: The macroeconomic effects of political uncertainty are more likely to unfold gradually than rapidly. An exception would be Turkey, which is more vulnerable to political shocks because of its large and growing external financing needs.
So what could go wrong?
With an expected slowdown in Chinese growth now unfolding, a decline in commodity prices could weigh on growth prospects for EM commodity-exporting countries. However, the context and nature of this Chinese slowdown are quite different from those in 2015. Property sector inventory dynamics have improved substantially, Chinese deleveraging can now take place against a backdrop of strong external demand, and Chinese supply-side reforms can potentially support commodity prices even as property-related demand weakens. As a result, a hard landing in China seems unlikely.
Growth forecasts aside, EM investors should consider recent changes in the “plumbing” of the global financial markets that have the potential to magnify small shocks.
Specifically, the rise in systematic investment strategies using momentum and asset volatility to determine the level of risk-taking is inherently pro-cyclical. Also, the shift toward more passive investing in recent years has reduced the pool of active, value-seeking capital that has historically stepped into market voids.
The good news, however, is that these pools of passively managed and momentum-driven capital remain relatively small, and many investors are still actively aiming to exploit valuation dispersion when it occurs to generate alpha. Particularly in EM fixed income, we believe active management offers the opportunity to capitalize on dislocations borne of these plumbing problems.
Even if the plumbing is suspect at times, EM still seems to be sitting on high ground.
For more on emerging markets and the global economy, see our cyclical outlook for 2018, “Peak Growth.”
Gene Frieda is a global strategist based in PIMCO’s London office and a regular contributor to the PIMCO Blog.