Following a challenging year, 2014 has started off with continued volatility. Some clients are asking their advisers about risks in emerging markets while others are wondering if the turmoil presents a buying opportunity.
Encouragingly, the strong economic fundamentals that have driven emerging markets debt over several years remain largely intact, technical dynamics are supportive, and valuations have improved. Developed economies are gaining traction, removing a headwind in place for several years.
Significant risks remain, however, and country differentiation and asset allocation will be a key theme this year. Recent volatility in the asset class stems from two broad types of risk: those specific to the countries themselves, and those presented by a less predictable U.S. interest rate environment. Also, uneasiness persists regarding China's economic rebalancing.
NOT ALL EMs ARE PAINTED WITH THE SAME BRUSH
Brazil and South Africa's diminished growth prospects, and anti-government protests in Turkey, Ukraine and Thailand are high-profile examples of sovereign risk that have damaged sentiment recently. These stories are balanced by countries such as Mexico, Colombia and the Philippines that are reaping the rewards of market-friendly reforms. Several Eastern European countries are benefiting from an ongoing recovery in the European Union, while Sub-Saharan Africa offers investors a fresh selection of rapidly-expanding economies.
The sudden increase in U.S. Treasury yields beginning in May 2013 left investors anxious about the transition away from years of exceedingly easy monetary policy. Though interest rates appear set to climb, the speed and magnitude will be muddled by conflicting signals about the U.S. and global economic recovery. Importantly, subdued inflation is allowing major central banks to commit to a low rate environment through 2014.
The ramifications of reduced global liquidity have been borne by emerging market currencies; several have depreciated 5-20% versus the U.S. dollar over the past year. In the process, markets have tested local-currency bonds in countries like Brazil, Indonesia, and Turkey as investors and central banks struggle to calibrate interest rate differentials between developed and developing countries. Encouragingly, floating exchange rate regimes in emerging markets are playing their designed role of acting as economic shock absorbers and preventing more damaging dislocations.
Diversified opportunities in emerging markets fixed income ensure that not all assets have or will perform similarly. Within local markets, Hungary, Romania and Nigeria delivered positive returns on an un-hedged basis last year. In U.S. dollar bonds, many high yield sovereigns posted gains, moderating the losses in interest rate sensitive investment-grade securities. Emerging market corporates have been more resilient on whole, given their short! er duration profile.
AN ATTRACTIVE ENTRY POINT
The yield back-up across assets is providing an improved entry point for investors. The spread on U.S. dollar sovereigns, close to 350 basis points over U.S. Treasuries, is above the 10-year average. Emerging market corporate bonds offer significant spread premiums over similarly-rated U.S. corporates, and emerging markets' domestic interest rate differentials are at five-year highs versus U.S. Treasuries.
Valuations are enhanced given that economic fundamentals in emerging markets have improved and remain largely superior to developed countries. Though expanding slower than recent years, emerging economies maintain their growth edge, and they run more balanced budgets. Public indebte