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Pivoting to green shoots

May 7, 2019

We see Emerging Markets fundamentals gaining traction in the second quarter, propelled by green shoots in China, a stabilization of global growth and supportive oil demand.

Highlights

  • EMD’s strong first-quarter returns were driven by easing financial conditions, after the dovish Fed and ECB pivot, by attractive valuations and by expectations of a US/China trade deal.
  • We see EM fundamentals gaining traction in the second quarter, propelled by green shoots in China, a stabilization of global growth and supportive oil demand.
  • As a result, we expect EMD performance to stay strong. As we see idiosyncratic risk on the rise in some countries, a strong focus on selection seems to be key.
  • A risk to our outlook is a continuation of European weakness that could increase global risk aversion and result in a rise of the US dollar.

Outlook and strategy

Emerging markets had a good run in the first quarter of the year, as a global policy shift reduced the uncertainties that hit the market in 2018. Slower macro data led the US Fed to turn more dovish, while market volatility brought the US and China closer to a trade deal. These factors led EMD to spring back from cheap valuations, yet the rally started to lose momentum in March as investors grew concerned about the extent of the slowdown, the risks of a hard Brexit, and the resulting US dollar strength.

We maintain a constructive approach to EMD, willing to stay directionally long for three reasons. First, there is sufficient policy support in place (plus willingness to add more) for us to look through the bottoming of the EM growth cycle. The Fed has paused, the ECB announced a new targeted long-term refinancing operations (TLTRO), and some EM central banks cut rates.

Second, our analysis shows there are early signs EM growth has started to turn the corner, led by China. We expect these green shoots to grow stronger as we advance into the quarter. Third, the global search for yield remains strong, with almost 20% of the Bloomberg Global Agg. now at negative yields (up from 12% in the third quarter of 2018), EM higher yields stay attractive – north of 6% for US dollar and locally- denominated debt, represented by JPMorgan indices. Not surprisingly, EM debt has seen more than USD34 billion of inflows in the first quarter, which we believe could accelerate should economic activity improve.

While we believe the market is heading in the right direction. Year-to-date performance comes on the back of risks being de-priced, while a second leg up depends on a pickup in global growth. We stay mindful of three kinds of risks: further disruptions to global trade (no US/China deal or tariffs on autos), engrained recessionary forces, EM potential idiosyncratic stories (e.g. Argentina elections, Turkey policy mistakes, Brazil reforms stalling), and the direction of the US dollar.

We expect local currency debt to deliver strong total returns if the US dollar finally weakens going forward. For investors seeking a less volatile path, unconstrained and hard currency strategies (sovereign, corporate or short duration) could deliver strong risk-adjusted returns.

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Sergio Trigo Paz
Head of BlackRock's Emerging Markets Fixed Income
Sergio Trigo Paz, Managing Director, is Head of BlackRock's Emerging Markets Fixed Income within Portfolio Management Group.
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Pablo Goldberg
Portfolio Manager, Head of Emerging Market Debt
Pablo Goldberg, Managing Director, is a Senior Strategist and a voting member of the team's investment committee.
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