Emerging markets (EMs) have been largely out of favor in recent years, as headline noise in the most vulnerable countries has appeared to drive investors away from the asset class. But investors who have shunned EMs as a whole are missing out on a massive opportunity set. EMs currently account for more than half of the world’s GDP and around two-thirds of GDP growth—that economic share is only expected to rise as EMs are projected to grow faster than developed markets (DMs) in upcoming years. On the whole, we see a number of exceptional valuations across the EM local currency markets that have often represented once-in-a-decade investment opportunities. The macro profiles of each country vary quite significantly across the asset class, so taking a selective approach will be crucial to unlocking the strongest returns while avoiding the pitfalls. Nonetheless, investors need to return their attention to EMs, in our opinion, as we believe the asset class offers some of the most compelling valuations available across the global financial markets.
Local Currency Markets Have Expanded Massively
The EM debt market has grown rapidly over the past two decades, with outstanding EM government and corporate debt expanding from $0.6 trillion in 1995 to $17.1 trillion in 2016. This growth has been predominantly driven by a greater issuance of local currency bonds (issued in domestic currency), and a proportionally lower issuance of hard currency bonds (issued in US dollars or euros). The local currency government debt market is now more than eight times larger than the equivalent hard currency market. But importantly, that rapid growth has not been accompanied by an increase in total sovereign indebtedness, as the average debt-to-GDP ratio for EM countries has actually dropped from 53% in 2001 to 48% in 2016. Economic strength and larger domestic investor bases have bolstered much of the expansion in issuance and the simultaneous decline in average indebtedness. The net effect in many cases has been improved access to capital for the sovereigns, reduced costs of capital, improved local market liquidity, lower credit risks for investors, and a vastly expanded global opportunity set.
Near-Term Volatility Has Generated Extraordinary Long-Term Value
Despite the strong expansions of local currency markets, EMs have had to endure periods of market volatility in recent years that have often driven foreign investors away from the asset class. Ironically, local currency bonds have tended to be more liquid than hard currency bonds during periods of risk aversion as domestic investor bases step in to buy local currency bonds, even as foreign investors may be fleeing them. Some of the traditional perceptions about the hard currency bond markets often appear to be mistakenly applied to the local currency markets, when in actuality the local markets have had a much broader support base. Investors who can recognize the differences in these markets have been able to capture better investment value, in our view. Periods of heightened risk aversion have at times greatly exceeded the actual underlying fundamentals in specific local currency markets, which has often depressed valuations in the short-term, but simultaneously provided tremendous longer-term investment value. For example, market pricing during risk events in 2016 occasionally reached extremes that implied conditions were worse than they were during the 2008 global financial crisis, or the 1997/1998 Asian financial crisis. Yet, underlying fundamentals for many countries were nowhere near crisis levels, nor were conditions uniform across the asset class, in our view. We believe avoiding the asset class altogether would lead investors to miss extraordinary valuation opportunities in a number of the most resilient economies.
Emerging Market Debt: Grew from US$0.6 trn in 1995 to US$17.1 trn in June 2016
As of June 2016
Source: Bank for International Settlements, Institute of International Finance.
Select Economies Remain Resilient
Overall, we have positive outlooks for several local currency exposures in specific EMs that we view as undervalued, notably Mexico, Brazil, Argentina, Colombia, and Indonesia, among others. Despite market apprehension that protectionist US policies could damage global trade, several EMs have already weathered severe shocks over the last year and are far more resilient to potential increases in trade costs at the margin than markets have indicated. In fact, several EMs have significantly improved their resiliencies over the last decade by increasing their external reserve cushions, bringing their current accounts into surplus or close to balance, improving their fiscal accounts, and reducing US-dollar liabilities. Markets have tended to overplay the potential US policy factors and under-recognize the more important domestic factors within the countries, in our opinion. Specifically in Latin America, we are optimistic about the turnaround stories in Brazil and Argentina, and about the boost of growth in Colombia. Ironically, as populist political risks rise in Europe and the US, countries such as Brazil and Argentina have recently turned away from previous failed experiments with populism and have moved toward more orthodox policies, taking pro-market and fiscally conservative approaches while maintaining credible monetary policy, proactive business environments and pro-trade regimes. Indonesia is also a strong example of EM resiliency. Commodity prices collapsed, trade volumes declined and China’s growth moderated, yet Indonesia’s economy has still been growing at 5%, with a balanced current account (including FDI). Additionally, even as 2016 saw widespread depreciation in EM currencies there have been no solvency issues for sovereigns like Indonesia. Twenty years ago, it would have been more difficult for EM countries to weather simultaneous shocks to trade, commodity prices and exchange rates. Yet today these countries are in much stronger positions to handle macro shifts and the changes to global trade dynamics.
Foreign Capital Appears to Be Returning to Emerging Markets
Overall, we continue to see a subset of EMs that we think have excellent value and better underlying fundamentals than markets have indicated. In recent months, markets have appeared to come around to a similar view as investors have incrementally returned to the asset class. A lot of foreign capital had exited those markets in recent years—when it flows back in, the valuations in those asset categories tend to recover quickly. In our view, we are still at the early stages of foreign capital returning to emerging markets, but we see a lot of upside potential ahead, particularly for select local currency exposures in specific areas of Latin America and Asia.J.P. Morgan Emerging Markets Currency Index
As of February 28, 2017
For illustrative and discussion purposes only. Past performance is not an indicator or a guarantee of future performance. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Source: J.P. Morgan Chase & Co., as of 2/28/2017. Important data provider notices and terms available at www.franklintempletondatasources.com.
Michael Hasenstab, Ph.D.
Sonal Desai, Ph.D.
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