In the face of heightened volatility and a looming U.S. interest rate hike, emerging-markets debt has shown resilience over the past six months, with solid single-digit returns across many sectors. That said, performance has varied widely by sector, underscoring the importance of an actively managed approach. Also, economic growth in emerging markets slowed earlier this year, narrowing the advantage those countries have had over developed markets.
Looking ahead, however, the stage is set for a pickup in emerging markets. As a base case, we expect developing economies to keep muddling through until a developed markets–led global recovery gains steam later this year. Emerging-markets economies have room to implement some countercyclical policies, which would be a crucial step in light of questions about the global economy’s position in the economic cycle. Furthermore, in anticipation of a Fed monetary tightening, many emerging markets have adopted tighter fiscal policies. At the same time, there is also scope for emerging-markets central banks to cut interest rates and implement further easing.
One particular issue for emerging-markets investors to consider is China. Its economy grew at an annualized 7 percent during the first quarter of 2015, a rate that will probably be that economy’s new normal. Lower, more sustainable growth is an inevitable part of its rebalancing process, though China is well placed to facilitate this process and ensure an orderly transition. Structural growth challenges persist, however. China’s economy is still highly leveraged and suffers from considerable excess capacity, traits that have weighed on the effectiveness of conventional policy stimulus.
The key risk for the rest of the year for emerging-markets debt, however, remains the Fed. The outstanding question is not whether the Fed will tighten but, rather, the pace and trajectory of policy normalization and the degree to which the U.S. central bank is perceived to be behind the curve.
The taper tantrum of 2013, which sparked a sell-off in global risk assets, was triggered by the Fed’s first mention of a possible gradual reduction of its quantitative easing program. We aren’t likely to see a repeat of this during this presumed change in Fed policy, however, for three main reasons:
•The impending rate hike has been well telegraphed, and investors are much better prepared for Fed normalization.
•Positioning is considerably less crowded this time around. In the lead-up to the taper tantrum, emerging-markets debt had experienced strong inflows that exacerbated outflows.
•Valuations are cheaper than they were before the taper tantrum, whereas currencies have adjusted.
Differentiation thus remains essential for investors in emerging-markets debt. Here are three reasons why:
Refinancing needs and capital flows. Some countries will fall under closer scrutiny when the Fed begins to normalize policy. Those considered most susceptible to a Fed rate hike are Argentina, Mongolia and Turkey. These are all countries with high current-account deficits and short-term refinancing requirements. At the other end of the spectrum are countries that are net exporters of capital and U.S. dollar liquidity, such as China. These will likely fare considerably better should capital flows become more volatile.
Domestic and external growth drivers. These countries have not been hit by a domestic slowdown and are well positioned to benefit from a global recovery. Examples include countries in Central and Eastern Europe positioned to benefit from a recovery in core Europe, as well as countries that stand to benefit from a generalized pickup in global activity, such as China, Mexico and the Philippines.
Policy flexibility. Central banks need the capacity to implement accommodative policies and, ultimately, to identify the markets in which taking long and short positions makes sense.
One way to address the growing complexity of sector selection within emerging-markets debt is a blended investment strategy that allows the flexibility to switch between segments of emerging-markets debt, like local or foreign-denominated debt, or sovereign versus corporate, and the ability to make tactical adjustments to the risk positioning of a portfolio. The choice of a blended benchmark offers different beta and volatility characteristics than traditional single-sector benchmarks. A mix of different beta and volatility characteristics can provide a more balanced risk-return profile in the longer run.
Zsolt Papp is a senior client portfolio manager with the global fixed-income, currency and commodities group at J.P. Morgan Asset Management in London.
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