In the past, a hiking cycle, and especially a strengthening US dollar, has proven difficult for the emerging world: during the 2013 Taper Tantrum, the mere hint of a wind-down of QE was enough to trigger a big sell-off and lay the foundations for a bear market.
However, our base scenario is one of continuing decent global growth with low inflation but without the reflationary Trump Trade risks of late 2016. In these circumstances, markets that offer organic growth become relatively attractive. When they look relatively undervalued, too, the pull becomes even stronger. Both conditions arguably hold for emerging markets today.
Cyclical indicators in emerging markets have been ticking up since the start of the year and even countries such as Brazil and Russia, which suffered most in 2014 and 2015, are now showing signs of recovery. Current controversy aside, Brazilian President Michel Temer’s ambitious reform programme, which includes pension and labour changes along with greater foreign investment, is having a positive effect.
Growth is improving in Russia too, albeit slowly. Elsewhere, Argentina, India, Indonesia and Mexico have all seen impressive reforms implemented over the last couple of years unlocking a higher growth potential. With currency adjustment and interest rate increases, many EM countries have seen their current accounts narrow dramatically.
Going forward, we remain positive on emerging markets fundamentals. External vulnerabilities remain at multi-year lows, and several countries are now in a position of rebuilding FX reserves and easing monetary policy. We continue to see improving fundamental developments in core countries like Brazil, Russia and Indonesia, and strong global growth should support exports going forward. Emerging markets corporates and consumers, China aside, have deleveraged and adjusted to lower commodity prices.
Of course, there are plenty of risks still out there, particularly in sovereign bonds – Venezuela has been a key example. More generally, if the US economy were to slip into reverse (something few are currently projecting), that would also have a negative impact on emerging markets debt.
The key risks that we see for the asset class as we enter the second half of the year are extended investor positioning in some areas of the market, tightening in Chinese monetary policy, and slower growth in the United States.
Overall, however, the outlook for emerging markets debt remains positive. Growth is more sustainable, current account deficits have been greatly reduced and vigorous reforms are gaining momentum.
In terms of market segments, we believe sovereign and corporate debt still look attractive on a relative basis, although spreads have tightened considerably. Currencies have been on the way up, but we still think they are under- rather than over-valued. Interest rates are still at reasonable levels, and various EM central banks, such as in Russia, Brazil and Colombia, are easing rates or will likely be easing given prevailing output gaps.
Rising inflation in aggregate still looks like a distant event rather than an imminent probability. In 2016, there were elevated default rates in the EM corporate space, led primarily by issuers in Latin America following the collapse in mining and energy stocks. But default levels this year have fallen.
I’m often asked why it makes sense to invest in emerging markets debt. First, I say that investors generally are underexposed to this asset class. The emerging debt market now exceeds $18trn and is growing rapidly as new issuance comes to the market. Second, it’s hugely diversified in terms of countries, currencies and industry sectors. Third and most important, it currently presents a yield advantage over developed market bonds. With fundamental improvements across EM countries, we believe that this risk premium could narrow over time.
Rob Drijkoningen is co-head of emerging markets debt at Neuberger Berman