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Mark R. Kiesel
Emerging markets have disappointed investors in recent years: Growth is slowing and has underperformed high expectations, whereas developed market growth is gradually picking up and has outperformed relatively low expectations. Inflationary pressures in emerging markets have caused some central banks in these regions to tighten monetary policy, while low inflation in developed markets has allowed their central banks to maintain highly accommodative policies to promote growth. Investors are questioning the sustainability of some emerging markets growth models, particularly in China and Brazil, given the exhaustion of past sources of growth and the need to promote new ones. Furthermore, governments in some emerging markets (EM) have caused a significant rise in geopolitical concerns, as in the case of Russia with the Crimea/Ukraine crisis, or they have adopted more state-run and less market-friendly policies that many would argue are constraining long-term investment and economic growth.
These are headwinds, to be sure, but longer-term investors can still find opportunities – particularly when market participants, traders or more short-term-oriented investors turn negative on an asset class or market with supportive long-term fundamentals. We believe this is what is happening with EM now. Relative valuations have improved significantly, and we think the technical outlook could turn less negative over time as investor sentiment improves. It may be time for investors focused on the longer term to begin to selectively add emerging markets back into their portfolios.
Global perspectiveOur firm’s portfolio management and credit research team coordinates and shares global and regional insights daily, leverages our top-down and bottom-up resources “on the ground” and travels to meet with companies all over the world to research and uncover investment opportunities. One thing my global colleagues and I have appreciated is the perspective that traveling gives us. Before elaborating on EM, I’ll point out that in recent years, we have come to appreciate even more what the U.S. has to offer:
Granted, many developed market economies have some or more of these features. Nevertheless, we are “Bullish on America,” favoring many U.S. industries including energy, housing, building materials, airlines, gaming, autos, auto parts, hospitals and banks. In fact, the U.S. equity market, as measured by the S&P 500 Index, has significantly outperformed emerging market equities, as measured by the MSCI Emerging Markets Index, over the past two years (Figure 1).
We left for Brazil cautious – you could even say mildly bearish – on the country due to concerns over increased government involvement in the economy and especially in state-owned enterprises that some believe have been used as “agents for social policy.” The poor infrastructure system and unattractive investment conditions for the private sector have been detracting from companies with a low cost of production in sectors like agriculture and basic commodities. High unionization and the complex tax structure also make the economy less competitive. Lastly, we worried about Brazil’s external vulnerability to global growth and in particular to a China slowdown.
When we got to Brazil, we were surprised to find that locals were even more pessimistic than we were. This can be seen in Brazilian business confidence (Figure 2), which has come under significant pressure due to concern over inflation, softer economic growth, high taxes and increasing government involvement and influence. The highly bearish sentiment was consistent across almost all the companies we visited.
After four days and 16 meetings, on the way to the Sao Paulo airport, I asked our team three questions about Brazil’s future:
1) Will fundamentals look better or worse relative to what the market is pricing in over the next 1-2 years?
2) Are technicals and investor positioning in Brazil likely to get more negative or positive from current positioning?
3) Is investor sentiment toward investing in Brazil likely to get worse or improve?
Our answers were (1) likely better, (2) more positive and (3) improve. Simply put, there comes a point to take the road less traveled, when a lot of bad news is priced in.
The global credit team left Brazil more bullish, a significant change from the past few years. Our main conclusion was that sentiment was so negative that markets had likely overshot and could improve from depressed levels given that relative value had finally become attractive. We also felt the highly negative sentiment was overwhelming the market’s pricing of risk, which may have been ignoring numerous long-term strengths in Brazil. These include the country’s large and low-cost natural resource base, favorable demographics, healthy and well-regulated private sector banking system and democratic system where the government is gradually making progress on some fronts (e.g., airport and road concessions). Finally, the team felt that government approval ratings had deteriorated so much as a result of protests over rising prices, poor public services, a deteriorating fiscal deficit and government over-reach that negative opinion polls could be a positive catalyst for change.
Emerging markets’ relative value improvesWe believe emerging markets’ relative value has improved for both interest rates and credit. In the case of interest rates and specifically for Brazil, the country now has high real short-term policy rates relative to many other developing and developed markets (Figure 3). Brazil’s term structure of interest rates, as reflected in the front end of the Brazilian swap and bond market, is pricing in rate hikes that are unlikely to materialize over the next few years. We believe this provides an opportunity for investors who are focused on the fundamentals in Brazil, which suggest growth is slowing, and that the current level of real rates is too high given a long-term and still-positive secular view of the country.
Central banks are supportiveA main question for emerging market investors now is whether the asset class can handle higher U.S. interest rates. In spring 2013, higher rates in the U.S. and fear of the Federal Reserve tapering its asset purchase program caused significant EM outflows, heightened volatility and underperformance. We believe a repeat of last spring is unlikely given better market positioning and technicals as well as improved transparency and communication from the Fed on the likely amount and pace of tapering. Given low inflation, the Fed is also in no rush to raise short-term interest rates. We think the earliest we could see a rise in the fed funds rate is in the second half of 2015. With wage gains and inflation low (Figure 7), any eventual Fed rate hikes should be gradual, as should any rise in U.S. intermediate-term interest rates.
Opportunities in emerging marketsEmerging markets have underperformed expectations but the longer-term secular outlook remains constructive for many regions. Importantly, and as a result of highly negative investor sentiment and outflows, relative value in the emerging markets has improved significantly. The outlook for the Fed and other developed and emerging market central bank policies should also remain supportive for emerging markets.
Today, we see opportunities in emerging markets in interest rates, sovereign credit and select companies for investors with a longer-term investment horizon. PIMCO’s portfolio management and credit research team is in a unique position to take advantage of these opportunities due to our firm’s global presence, coordination and on-the-ground research capabilities.
Mark Kiesel Deputy CIO
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
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