Young global economic expansions typically fuel strong gains in emerging markets (EM) assets. As the economic cycle moves from recovery into expansion and risk aversion declines, waves of capital generally flow into emerging market assets, weakening the dollar, which further reinforces the capital flow cycle to EM. We believe we have entered such an expansion phase. Although we are vigilantly monitoring the pandemic’s ongoing impacts, we believe that accelerating growth, combined with ultra-loose monetary and fiscal policies and attractive relative valuations, should support EM investments for a prolonged period.
From healing to expansion
Cyclical indicators suggest the global economy is swinging into an expansion phase. The global manufacturing PMI – a good proxy for economic activity – has moved above its historical average, and rising prices in commodities and other cyclically sensitive assets have manifested. We believe this trend will continue, supported by an extended period of massive monetary and fiscal stimulus, as many countries likely won’t see a full recovery in output and employment until well past 2021. Importantly, we find that the broad traded-weighted dollar weakens 77% of the time when the global manufacturing PMI reaches this stage. A weaker dollar is a significant booster to EM returns (see Figure 1).
Vaccination campaigns and private sector re-engagement add predictability to the nascent recovery. The confidence boost stemming from the rollout of vaccines will give way to fresh private sector engagement, particularly in areas most affected by the restrictions to mobility. Pent-up demand in relevant sectors of the global economy can give renewed strength and length to the reboot in growth. We think country-specific issues will again be relevant later in the year, but for now these global drivers should take center stage in boosting demand for EM assets.
Figure 1: Emerging markets returns throughout phases of the global growth cycle*
Dollar depreciation could boost EM returns
Currencies are the conduit for easier financial conditions to permeate EM, and dollar cycles tend to be long-lasting affairs (see Figure 2). The U.S. dollar is coming from a period of significant outperformance. Given above-trend broadening global growth, ongoing vaccine rollouts, and a very accommodative Federal Reserve, we believe the next phase of the dollar cycle will likely track its usual post-U.S. recession pattern and depreciate. The prospects for additional fiscal stimulus with a new Democratic Senate majority likely will accelerate this trend.
Figure 2: The U.S. dollar may be at a pivot point
We favor local EM assets over external credit
Our asset allocation decisions in emerging markets portfolios typically revolve around contrasting “balance sheet” assets that are largely driven by sovereign debt levels, and “income statement” assets that are more sensitive to nominal growth (see Figure 3). Given our forecast for a global economic expansion and reduced volatility, we see more value in pro-cyclical growth-sensitive assets, namely FX, equities and rates, versus credit.
The timing is attractive, in our view. Positioning in FX, equities and rates is not extended, potentially providing an early-mover advantage. Flows to these parts of the EM complex have been modest if not negative in the last two years. Yet, if history repeats itself, reversals in capital flows will be large and swift, and will more meaningfully impact areas, such as these, that have been out of favor with offshore investors.
Our baseline scenario is not without risks, however. Risks include the Fed tightening prematurely and the dollar strengthening, the expansion being interrupted from slower-than-expected COVID-19 containment, or a tapering of stimulus in China so heavy-handed that it dents expectations for global growth and commodity prices.
Given significant slack in labor markets and subdued inflation risks, we believe monetary and fiscal authorities will continue to act to avoid any undesirable tightening or loss of growth momentum. These global “push” forces should remain primary drivers of EM markets in coming quarters. We anticipate country specific “pull” factors regaining relevance later. Should the Fed tighten sooner than we expect, weaker EMs would normalize monetary and fiscal policies faster as well. To account for these risks and above-average valuations for financial assets in general, we will continue to focus on maintaining liquid and diversified portfolios.
Figure 3: PIMCO emerging market balance sheet vs. income statement framework
Figure 4: PIMCO emerging markets asset allocation preferences
Our conviction at this point in the cycle has increased that the demand for safe-haven dollar assets will decline as the global recovery broadens and uncertainty recedes. In turn, we prefer exposure to high-carry EM currencies versus cheaper and more growth-dependent value currencies, which are pricing some degree of idiosyncratic stress. Some of the higher-yielding currencies we like include the Chinese yuan renminbi (CNY), the South African rand (ZAR), and the Mexican peso (MXN). Eventually, we expect a drop in EM FX volatility from currently elevated levels to support higher-beta currencies as risk premiums compress further – providing rotation opportunities as the cycle advances.
Levered to the global economy with a high share of cyclical sectors and a negative correlation to a weakening dollar, we believe EM equities have room to continue to appreciate. Although valuations look rich on a historical basis, with the MSCI EM’s forward price-earnings ratio trading at 16x, versus a five-year average closer to 12x, gains from multiple expansion are the norm exiting recessions. Going forward, we expect EPS growth will drive prices. To be sure, coming off six years (2013-2019) of near-zero compounded EPS growth for MSCI EM, we believe the combination of cyclical lift to operating leverage and appreciating currencies should support positive earnings revisions in the quarters ahead. We are reducing our preference for Asian markets, given strong gains since November. Within Asia, we maintain our focus on new economy sectors. But we believe gains will broaden to other regions that have lagged the recent rally and offer more attractive valuations, warranting select exposure to other cyclically oriented sectors in EMEA and Latin America.
Local duration (sovereign debt denominated in local currency)
We believe EM local duration will become a key beneficiary of the strong capital flow cycle toward EM and the weakening dollar that we foresee, and offers both good potential risk-adjusted returns and a diversifier to global rates allocations. Local curves are very steep, providing the opportunity to harvest premium by positioning in shorter maturities.
Room for significant additional rate cuts is limited, but the market is pricing rate normalization paths that are too aggressive, in our view. We think economic slack and strengthening EM currencies will help anchor inflation at low levels, allowing central banks to continue their highly accommodative monetary policies.
Countries that stick to sound fiscal policy paths can see significant curve flattening for long-end maturities. Specifically, we are focusing on five- to seven-year durations in countries where yield curves are steep but anchored by monetary policy, allowing for high real yields associated with fiscal or political contamination to be harvested. South Africa and Peru fall into this category.
Figure 5: Emerging markets 10-year real rates remain attractive vs. domestic markets
EM external (denominated in hard currency)
- Sovereigns: EM sovereign credit remains a natural destination for crossover investors looking for liquid alternatives away from ultra-low rates and rich credit valuations in developed markets. This should continue to support steady inflows into the asset class. Balance sheet deterioration has occurred in EM, but overall debt servicing costs have been relatively stable for key countries. The investment grade segment of the market has retraced to pre-pandemic spread levels, although we still like exposure to certain high quality sovereigns.
We see more value in higher-yielding names. Although we anticipate lower default rates going forward, the risk of policy mistakes in lower-quality credits has not disappeared, and credit selection will remain a key attribute in driving alpha once the influence of external drivers subside. We have an emphasis on:
- Core positioning in higher quality and more liquid names
- Selective participation in new issues, expecting lower supply versus 2020
- BB-rated credits that entered the COVID-19 crisis with good fundamentals
- Countries with strong multilateral support
- Limited exposure to fallen-angel candidates
- Reducing exposure to significant commodity importers
- Corporates: EM companies managed to reassert their solid fundamentals following the initial shock to revenues in the first half of 2020. Financial discipline and controlled capital expenditures helped keep leverage ratios contained and net financing needs low. The default rate closed 2020 near 3% and distressed exchanges were limited to service sectors most impacted by COVID-19. We expect the higher weighing toward investment grade and the lower duration of the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) benchmark to continue to anchor spreads.
Corporates have outperformed sovereign benchmarks and their relative valuations are now converging to the five-year average. Therefore, we advocate a more selective approach focusing on BBB and BB names in relatively stable countries. Low local interest rates should continue to offer EM corporates opportunities to replace hard currency debt with local currency debt, further improving the supply-demand technical position for some issuers in the CEMBI. Sectors we favor include Central & Eastern Europe, Middle East, and Africa (CEEMEA) and Asian technology, media, and telecommunications (TMT), dominant EM financials, low-cost commodity exporters, and EM REITs. We believe LatAm is the most vulnerable region and are also watchful of large issuance coming from Asia.
Global factors have aligned favorably for emerging markets assets. We find that gains tend to be the strongest in the early parts of a young expansion when financial conditions remain ultra-accommodative and the dollar weakens. We believe these trends have good staying power and advocate higher allocations to EM assets. On a risk-adjusted basis, we prefer local assets to external credit. Later on in the cycle, differentiation and dispersion of returns will emerge again – stressing the need to keep portfolios diversified, a core pillar to PIMCO’s rigorous investment process.
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