After a good spell outside of the limelight, emerging market strategies turned things around and became some of the best performers in 2016.
Funds focused on the developing markets reaped the benefits of the strengthening dollar and the move away from monetary loosening under the quantitative easing (QE) policies pursued by developed governments since the onset of the global financial crisis.
Jan Dehn, head of research at London-based emerging markets specialist Ashmore, says QE provided “enormous support” for developed market bonds, but notes the widespread concern that this may now be changing.
Developed market bonds benefited from a low inflation environment, but with inflation expected to pick up conditions have now changed.
Dehn says historically there has been “quite a clear correlation between US equities and emerging market local currency bonds” but this broke down over recent years as US equities surged but investors ignored emerging market assets.
But higher inflation expectations have seen emerging market bonds and US stocks become more correlated following a period in recent years where the two diverged.
Returns of EM fixed income vs US stocks
Source: Ashmore
“I think we are returning to the long-term trends of positive correlation to the equity market in the US and emerging markets in general,” said Dehn.
“It’s because of the return of inflation expectations and QE being replaced with fiscal spending. The difference is quite significant: in QE the government buys bonds, with fiscal spending the government issues them.”
However, while QE may have been difficult for emerging market bond issuers, currencies have performed better, according to Dehn.
“Emerging markets have become incredibly competitive,” he noted, adding that emerging market real effective exchange rates have reached levels not seen since 2003.
Dehn says American companies have found it harder to compete against emerging markets in these conditions, warning that the US dollar may have become overvalued in recent years.
“When you look at performance during 2013, a lot of local currency bonds lost 10 per cent in dollar terms, US bonds with the same duration lost 0.5 per cent,” said the Ashmore research head.
As well as strengthening currencies, emerging markets are starting to see strong growth contributing to strong currencies.
“Growth bottomed out in 2015, but the pick-up seen in 2016 had nothing to do with flows because emerging markets didn’t get any last year,” he added.
Dehn says that a 35-year rally in bonds in the western world appears to be coming to an end, highlighting attractive yields in the emerging markets bond space, particularly in comparison with developed market bonds.
Emerging market bond yields
Source: Ashmore
Indeed, Dehn says that yields across all emerging market fixed income segments remain attractive.
Many investors have been alarmed by comments by US president-elect Donald Trump, both during the campaign and since his victory, and their potential impact on emerging markets says Dehn, but concerns may have been overdone.
Dehn says some of Trump’s policies may face challenges from his own party once they have achieved some of their shared aims, such as the overhauling corporate taxation and repealing the controversial Dodd-Frank Act.
“In the long term, there will be a push back from the establishment in the US,” he said.
The impact of a Trump presidency and more trade protectionism in the US is likely to see the world’s strongest economy retreat from previous spheres of influence, says Dehn, which is beneficial for traditional antagonists such as Russia and China.
The introduction of trade tariffs could ultimately reduce the flow of dollars externally, raise prices in the US and make exports more expensive, which also bodes well for emerging markets.
Ultimately, the biggest risks for emerging markets are likely to come from developed markets, where the political environment remains uncertain. With several headwinds on the horizon, investors may feel that emerging market fixed income remains too risky.
But for those seeking returns with a high risk tolerance, it may prove a tempting sector. Indeed, Dehn says institutional investors have been left alarmed by their lack of exposure to emerging market fixed income.