Emerging market (EM) local currency debt, as proxied by the JP Morgan GBI-EM global diversified index, returned nearly 10% in 2016 and 15.2% over the course of 2017. In light of these impressive gains it is worth asking whether the EM rally has room to continue.
We believe rising FX reserves and strengthening growth have supported EM FX over the past two years, and we expect both trends to continue in 2018.
In our view, EM seldom suffers a sustained sell-off when it is running a current account surplus. EM’s current account started to improve in 2013, but capital flows deteriorated at an even faster pace. The result was that the net inflows into EM were negative from mid-2013 to the end of 2015.
By early 2016, however, the current account had moved into surplus, and capital outflows stabilised. The result was a net inflow into EM, an increase in EM reserves, and a rally in EM FX that was interrupted only briefly by the US election.
The outlook for EM FX depends therefore on the prospects for capital flows. At present EM is experiencing a very small net capital outflow. For the (brief) history we have available, capital inflows have averaged USD 35 billion per quarter. In our view, it seems reasonable that capital should flow from developed markets to EM, where growth should be stronger and returns to capital higher. In terms of GDP, growth bottomed at 2.7% year-on-year in Q4 2015, and we expect the figure for Q4 2017 to be around 4%.
Credit growth in EM is well below nominal GDP growth, which in turn means that the debt to GDP ratio is falling. Encouragingly, EM is achieving strengthening growth and balance sheet repair at the same time.
In our view the growth outlook matters greatly for EM local currency debt. EM is a risky asset, and as such tends to perform well when growth is strong. To be bearish EM local currency debt from this perspective, you have to believe 1) that net capital inflows into EM will fall from starting levels of zero, and 2) that EM credit growth will fall from levels that are as low as they were in 1999 and 2008.
If credit growth and capital inflows increase as we expect, EM FX should perform well. At worst this would leave EM investors free to receive EM’s attractive yields. Under these circumstances we would expect EM local currency debt to return 5% to 10% in 2018.
At the same time, the outlook is not without risks. These include a stronger US dollar, a slowdown in Chinese growth and commodity prices, political risks, and positioning.
Recent indicators suggest an easing in credit conditions, and, if the tax reform package is passed and proves more effective than we anticipate, one could see US GDP growth heading towards 3.0% for 2018. Under these circumstances we could well see higher yields and a stronger USD.
Credit growth in China is too high, and as it slowed, the credit impulse turned negative and property sales stagnated.
The surge in property sales and related activities appeared to play a significant part in the increase in commodity prices, and it is not clear how they will respond to sustained housing weakness. We believe the strength of external demand and the gradual rebalancing towards the consumer will prevent a hard landing in China, and a gradual slowdown will not derail the EM investment case.
The big global political risk remains the US and its attitude to global trade. Progress in the NAFTA negotiations could have profound implications for Mexico in particular. However, any shift towards greater protectionism or higher tariffs would have a material impact on all EM FX.
At the same time, elections in Mexico, the reform process and elections in Brazil, internal party politics in South Africa and developments in Turkey could all increase the volatility of EM returns.
According to the BAML Global Fund Manager Survey, investors are as overweight EM now as they were in early 2013. The 2013 experience suggests that if everyone is overweight EM, sell-offs could be fierce. However the situation is very different from 2013, where EM was heading into its fourth year of outsized inflows.
In our view, current positioning, movements in the USD and idiosyncratic risks can all contribute to periods of volatility and negative returns, but they do not undermine the fundamental case for the asset class. While we will monitor these risks and try to either position for or hedge against them where appropriate, we do not think these risks should keep one out of the asset class. This is the volatility one faces when investing in risky assets. By trying to avoid these risks we believe investors are as likely to miss out on returns as they are to avoid losses.
Finally, despite the rally, EM valuations are far more attractive than they were in early 2013. EM bond yields rallied through 2017, and at 6.1% (as at the end of December 2017) they remain 70 bps below the 6.9% average we have seen since 2003.
A similar point can be made for the real effective exchange rates. While EM has rallied, EM local currency debt is not particularly expensive, and certainly not nearly as pricey as it was in 2013.
In all likelihood, returns will be more volatile going forward than in the past two years, but this volatility is inherent in the asset class and is not a reason to sell. The one fundamental risk we must monitor is China, where growth is slowing. For the moment we believe the slowdown will be sufficiently gradual, and therefore believe the investment case for EM local currency debt remains strong.