(Bloomberg) — The prospects for an economic recovery in China and a turnaround in the US Federal Reserve this year are bolstering emerging market bulls’ hopes. The stage is set, they say, for a much overdue broad rally in the asset class.
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Just don’t go all the way yet.
Key indicators for emerging-market equities, currencies and bonds rose in the five days to Friday after their best quarter since 2020. But there were some serious hotspots: Egypt’s recent depreciation signaled a fresh surge in volatility for the currency, while the Turkish lira hit an all-time low. The rand also collapsed as South Africa’s ruling party pushed for a broader central bank mandate.
Brendan McKenna, a New York-based emerging markets economist and FX strategist at Wells Fargo Securities, believes in the asset class’s potential to outperform this year. However, the ability to endure pain in the short term is required. The best approach is “tactical and selective,” he said.
The near-term pain McKenna is alluding to, particularly for emerging market currencies, stems in part from a lack of clarity about the Fed’s rate path. If anything, he said, the Fed is likely to keep raising interest rates and “eventually tightening more than financial markets are being given credit for.”
Should the Fed deliver too much and equity markets remain volatile, McKenna is banking on currencies associated with strong fundamentals, such as the Chinese yuan, to outperform. He also likes those with still restrictive central banks, including the South African rand and the Israeli shekel.
Fragile currencies like the Egyptian pound and Turkish lira could struggle in the meantime, he said. A dovish central bank could also exert downward pressure in Colombia.
The story goes on
Big steepener
For some investors in riskier emerging market assets, the US Federal Reserve’s pause in interest rate hikes is not enough. It must also state that it is about to start cutting.
A strong signal will come from the US bond market: the steepening of the Treasury yield curve. That’s what happens when shorter-dated securities — which are most sensitive to changes in policy — rally, pushing their yields down more than those on the long end.
“At some point, a slower pace of monetary tightening would not be enough to sustain the tactical rally in the medium term,” said Witold Bahrke, a Copenhagen-based senior macro strategist at Nordea Investment. “We need more tangible signs of a turnaround by the Fed, ie a full easing of monetary conditions.”
Bahrke expects the gap between the 2- and 10-year maturities to widen to about 50 basis points from about minus 70 basis points on Friday before turning fully bullish on emerging markets. Developing country assets will lead to a rebound in global markets once bulls regain dominance, he said.
For Eurizon SLJ Capital asset manager Alan Wilson, the Fed could turn around in the coming months as a policy-driven growth acceleration in China boosts demand for developing-world goods.
Local currency debt — complemented by a buoyant outlook for developing currencies — will lead the way, followed by external debt, Wilson said.
Of course nothing is certain. After the Fed hiked rates at the fastest pace since the 1980s, Fed officials have been unusually blunt in their warning to investors, warning in recent meeting minutes not to underestimate their will to keep rates high for some time.
Still, investors are pointing out that developing world central banks have been driving global interest rate hikes, helping to build a buffer against higher US real rates. Valuations are also attractive, particularly when growth differentials are factored in.
Economists polled by Bloomberg predict that the rate at which emerging markets will grow faster than developed markets will increase sevenfold to 3.5 percentage points by 2023. Should the US slide into recession, investors chasing growth will have little doubt as to where to head.
Emerging markets are also at an advanced stage of risk pricing. About $170 billion in portfolio money fled emerging markets between February and October, the longest and largest outflows since the global financial crisis, according to Deutsche Bank. About $104 billion came from the exodus from China’s local bonds and another $57 billion from North Asian equities, the bank said.
“If you’re underweight, you’ll never hit bottom. So you could gradually increase your exposure as EM assets – from bonds to equities to FX – are cheap by many measures by historical standards,” said Peter Marber, head of emerging markets at Aperture. “A US recession will most likely be superficial and could result in lower interest rates, if anything – all of which are likely to continue to drive EM asset prices.”
Something to see
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Trade and inflation reports from China will show the initial economic damage from the country’s easing of tough Covid restrictions
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According to Bloomberg Economics, exports are likely to fall further as the rapid spread of the virus disrupts factory work
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Falling prices for services and declining credit should also register the blow
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Inflation data from Mexico, Brazil, India, Poland and Russia should provide clues on the monetary policy outlook
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Peru is likely to continue its steepest string of rate hikes on Thursday in a bid to curb inflation
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The Czech Republic is due to release its GDP report Monday ahead of the nation’s first round of presidential elections, which will be held on Friday and Saturday
–Assisted by Sydney Maki.
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