The big global trade right now is emerging markets (EM). 
EM fixed income is already performing well and is supported by strong technicals after years of excessive selling. Asset prices moved, but EM fundamentals failed to implode over the last few years despite severe headwinds, including capital outflows, the dollar rally, falling commodity prices and Fed monetary tightening.
This has created a lot of value in EM, while there is precious little value left in developed markets.
EM is not just a value trade, however.
There are also two other powerful tactical reasons for allocating to EM right now. The first reason is that Brexit – a 21 standard deviation event for the pound – pushed VIX, the Chicago Board Options Exchange Volatility Index, up by more than 10 points relative to its 60-day moving average.
Performance of sterling versus the US dollar over 1yr
Source: FE Analytics
In the past, all EM fixed income asset classes have generated positive alpha to investors that have deliberately allocated to the asset class during episodes of 10+ spikes in VIX. The average alpha for allocations during VIX spikes is 3 per cent in the following twelve months. This is equivalent to a 41 per centhigher return than the average passively timed allocation.
The other tactical reason for considering an EM allocation now is flow-related.
Last week saw EM bond funds post the largest weekly inflow on record, despite a week shortened by holidays in the US and elsewhere, according to new data from JP Morgan.
The flows were broad-based and the bulk went to actively managed funds. This increase in flows comes on the back of strong performance year to date and proven resilience in the face of expectations of several rate hikes from the Fed this year and the volatility caused by the UK’s Brexit vote.
It is possible that EM allocations may soon become the subject of a broader momentum trade, having been out of favour for some time.
Performance of sector and indices in 2016
Source: FE Analytics
While keeping an eye on these tactical arguments for allocating to the asset class, we think investors should also carefully examine the value argument for EM. Recent research shows that investors can increase returns and reduce risks by expanding their EM exposure at the expense of their exposure to overvalued developed markets.
The bigger picture is clear: global financial markets have largely been driven by highly discriminate buying of developed market assets on the back of strong quantitative easing (QE) bids from central banks in developed economies.
But these big QE trades are nearing their end.
While central banks are still pursuing very loose economic policies in developed economies, asset prices in those economies offer an increasingly unattractive risk-return propositions.
The Brexit event was a powerful reminder that there are no risk-free markets. All markets are risky.
Investors should avoid, as far as possible, excessively exposing themselves to a narrow range of very overbought and risky securities in developed markets.
As this becomes clearer we expect the QE momentum bandwagon to give way to more value-oriented strategies that give greater confidence to investors that they are adequately compensated for the risk they are taking. And that means EM.
UK’s demise will barely register in EM
Global financial markets are still trying to come to grips with the implications of the UK Brexit vote. Our view is that Brexit is overwhelmingly a UK tragedy, but analysts have wasted little time extrapolating potential implications for the wider European arena, even for EM.
As far as the EM extrapolation is concerned, it has largely failed. After all, the UK accounts for less than 2 per cent of global GDP, so the country’s demise will barely register in most EM countries.
EM technicals are also strong, which means that there have been very few sellers. Without pregnant positions to help create momentum interest is fading in the press and among analysts.
Europe looks more vulnerable to contagion from the UK. Brexit will, so the narrative goes, cause a significant slowdown in the UK, which in turn will push Europe into recession.
Performance of indices in 2016
Source: FE Analytics
The slowdown in European growth will force the ECB to push interest rates even further into negative territory, which is bad for the banks. This is why the global markets are focussing on Italian banks, Deutsche Bank and attempting to revamp the old Periphery sovereign trades.
It would be wrong to underestimate the risks of a contagion into Europe. Brexit dovetails beautifully with the very broadly held consensus view that Europe is in deep trouble.
Our view, however, is that the scope for a big ‘sell Europe’ trade is currently limited.
One reason is that valuations in the US markets are very high. Shifting exposure from Europe to the US right now would therefore require buying very expensive assets. The strong dollar is already hurting the American economy.
Similarly, defensive European trades, such as buying government bonds in core Eurozone economies, are also unattractive due to negative yields. Indeed, at the current low yields an investor would have to hold a 30-year German government bond for 82 years in order to make up for the loss associated with just a 150bps move in the yield curve.
Note that, the yield on the German 30-year bond would have to by far more – 410bps – in order to return to its long-term average of 4.4 per cent.
There is also some validity to the argument that the European economy may not be nearly as vulnerable as many analysts and reporters would have us think.
The UK is in trouble, no doubt. Consumer confidence dropped to the lowest level in 21 years. But the European economy is not only the largest in the world, it is also highly diversified. European populations have, according to the most recent polls, become more, not less, enamoured of the European Union after the UK’s decision to exit.
Many Europeans simply think it was stupid of the UK to leave and Brexit has reminded them of the many benefits of EU membership.
Jan Dehn is head of research at Ashmore. All the views expressed above are his own and shouldn’t be taken as investment advice.
