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.
Our 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:
- Strong universities and an educated and productive workforce
- The rule of law and protection of property rights, which encourages entrepreneurs
- Vibrant private-sector investment and adoption of new technology
- Dependable and reliable infrastructure and public services
- Relatively low crime and corruption and an independent central bank
- Democracy and a system of checks and balances within the government
- Creative destruction where unproductive companies fail
- An energy revolution and a housing recovery
- A healing private sector with well-capitalized banks
- Competitive and profitable businesses with solid balance sheets
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).
Dispatch from Brazil
Last month, five of my colleagues and I traveled to Brazil, where we met with government officials, local investors and senior management in 16 of Brazil’s largest companies. Prior to our trip, our team met with our internal top-down macro experts on Brazil and did considerable preparation and research.
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.
We also noticed from our research that many local Brazilian investors were positioned defensively in Brazilian equities and credit and were negative on the currency and local bonds, with a view that interest rates would head higher.
After four days and 16 meetings, on the way to the Sao Paulo airport, I asked our team three questions about Brazil’s future:
- Will fundamentals look better or worse relative to what the market is pricing in over the next 1-2 years?
- Are technicals and investor positioning in Brazil likely to get more negative or positive from current positioning?
- 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 improves
We 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.
Compared with sovereign credit risk in Europe, sovereign credit in emerging markets has significantly underperformed. As an example, sovereign spreads in Brazil have recently come under pressure while sovereign spreads in Spain and Italy have continued to improve and tighten (Figure 4). We believe the recent widening in Brazil sovereign credit spreads provides an opportunity to add credit risk in a sovereign with supportive long-term credit fundamentals (a low external debt ratio and strong reserve buffers) at a time when valuations have become more attractive.
Relative value has improved significantly for certain individual credits as well. Spreads for Petrobras, one of the largest and most important energy companies in Brazil, have widened significantly relative to both the sovereign spread (Figure 5) and the U.S. credit market (Figure 6). The government’s policy of setting domestic gasoline and diesel prices below international market prices has caused large losses and resulted in increased balance sheet leverage for Petrobras. Nevertheless, we believe the Brazilian elections in October will bring Petrobras some relief to raise domestic gas prices in the long run, which should help improve cash flow. The company has been able to maintain capital market access – it issued $8 billion in debt last month – and we also believe it has significant financial flexibility through the quality of its assets and reserve base. Finally, should oil production growth ramp up as we expect, the company’s balance sheet profile should stabilize as cash flow improves.
Finally, relative value is allowing for many bottom-up opportunities in the banking sector. In Brazil, for example, credit expansion has picked up in state public sector banks but has slowed in private sector banks where underwriting standards were tightened several years ago. Private sector banks, including Itau Unibanco and Banco Bradesco, have also increasingly directed incremental growth toward lower-risk lending categories with asset quality metrics improving despite a challenging macroeconomic backdrop. We see select opportunities for investors to pick up spread in well-managed national champion emerging market banks versus developed market peers.
Central banks are supportive
A 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.
The European Central Bank and Bank of Japan monetary policies also remain highly accommodative. In addition, EM central banks are now better prepared for a withdrawal of quantitative easing and a normalization of monetary policy by the Fed. For example, several central banks in emerging markets (Brazil and Turkey) have hiked rates and have put in place mechanisms to smooth volatility in their currencies should there be another bout of weakness. Finally, investors are also better positioned for higher interest rates, so technicals are more supportive for the market than last year. In combination, we believe these developments should help risk assets, limit volatility and support emerging markets.
Opportunities in emerging markets
Emerging 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.