Emerging markets have performed well in the first half of 2019, a change from the challenging conditions seen last year. 
There have been two key factors to this turnaround. One is the return to a more dovish monetary policy in both the US and euro area, including admission that winding down central bank balance sheets is likely to be slower than planned. By suppressing returns in developed markets, this helps to push investors to seek better returns in higher risk sectors, not least emerging markets.
The other factor favouring them is greater confidence that global growth remains reasonably stable, in particular in the US and China. The two economies, the first and second largest, are by far the most important markets for emerging market goods and services.
The stable fundamentals of many parts of the emerging markets sector, together with economic policy credibility, have been further factors supporting good performance. Finally, cheaper valuations at end-2018 across many markets drove a large pick up in investor inflows.
Performance has not been universally positive, however. Emerging market sovereign credit (hard currency bonds issued by governments) has delivered the strongest returns, albeit with a few more challenging country specific situations such as Argentina and Turkey.
The strength of the US dollar, which helped lift hard currency outperformance, was a drag on the performance of local currency assets. According to JP Morgan, emerging market equities rose 12 per cent in the first four months of 2019, a solid return but below levels seen in the US and Europe.
Selective opportunity
Looking ahead, we feel opportunities will be selective. Global factors such as the strength of economic growth in China and stable monetary policy in the US are important, and in particular the path of the US dollar. Emerging market valuations are no longer as compelling as at end-2018 and investors have materially increased their exposure. Market participants will also be wary of protecting generally good performance for January-April, and are likely to be more cautious to deploy new risk, and quick to reduce exposures at signs of volatility.
On this view, the case for being more cautious is strong. While global central banks remain accommodative and have supported low yields globally, we are sceptical that the current low level of financial volatility will persist. This suggests that adopting a more defensive stance across emerging markets can put investors in a strong position to benefit from market disruptions at either a broad level (systemic) or a more specific situation (e.g. greater disruption in Argentina or Turkey). A fresh catalyst, such as a boost to emerging markets growth or a weaker US dollar, will help to support equity valuations.
The secular outlook
Away from the near-term market and trading outlook, we continue to see an allocation as an important part of most investor’s portfolio mix. Emerging markets countries represent an increasing share of global growth, yet their weightings in global bond and equity indices is well below this ‘economic’ contribution. Historical concerns over governance remain, despite emerging markets as a whole having improved greatly in terms of economic policy, transparency and state institutions. It is these residual concerns that provide the higher risk premia carried by many assets relative to developed markets, and a well-structured exposure to emerging markets can benefit from this.
There is a broad mix of assets within emerging markets as highlighted earlier, which provides opportunity to manage and hedge risks and provide portfolio diversification. A 20-year history of returns and volatility shows JP Morgan EM Bond Global Diversified Index, which is hard currency, generating an annualised return of around 9 per cent on manageable volatility (standard deviation) also around 10 per cent. This compares favourably with many equity classes (e.g. global equity, S&P 500) and is similar to US high yield credit, but with more diversified sources of return.
Equities provide a long-term opportunity to benefit from superior emerging market growth rates as well as a wide range of strong companies (often in weak sovereigns), but historically their returns have been similar to those of emerging markets hard currency sovereign bonds, with greater annualised volatility.
Emerging market countries do exhibit greater volatility than developed nations, but we believe this is largely reflected in pricing, and despite the media headlines, significant drawdown events remain relatively rare and are no less flagged than equivalent events in developed markets. The emerging market investor base has also matured in recent years, now comprising long term investors in asset management, central banks and sovereign wealth funds, together with a stable and rising domestic investor base such as banks, pension funds and increasingly retail investors.
Nick Eisinger is a fund manager covering emerging market sovereign credit. The views expressed above are his own and should not be taken as investment advice.