Global Weekly Commentary
Emerging markets in a sweet spot (for now)
- We are in a sweet spot for emerging market (EM) assets. We see selected opportunities, as key headwinds have abated for now.
- EM assets had a strong week as the U.S. dollar retested a six-month low and Argentina returned to bond markets.
- We see a window for EM assets to further outperform, but structural challenges could come to the fore later this year.
We are in a sweet spot for EM assets. The chart below shows how key headwinds for EM assets have abated lately, with a weakening U.S. dollar, a rebound in commodity prices and a recovering Chinese economy.
The Federal Reserve (Fed) has signaled it is set to keep rates on hold for now. This has lowered the near-term risk of EM capital outflows, weakened the U.S. dollar and boosted oversold EM currencies. China’s foreign reserves rose in March for the first time in five months. Also supporting EMs: firming oil prices, fading global recession fears and signs China’s economy may enjoy a cyclical rebound.
Can the sweet spot get sweeter?
EM-related exchange traded products (ETPs) have attracted nearly $16 billion this year, according to BlackRock research. EM ETPs have recouped 75% of their 2015 outflows, the “short EM” trade is much less crowded than it was at the start of the year, and EM valuations are no longer unambiguously cheap, our research suggests.
Fed tightening, a Chinese yuan devaluation or economic slowdown, and a renewed slump in oil prices are all risks to the EM story. We see the Fed remaining dovish through mid-year. Yet risks could return in the second half as U.S. rates increase and China’s credit-fueled growth improvement slows.
What would it take to get a sustained EM bull market? We would need to see evidence of structural reforms addressing excess debt, industrial overcapacity and low corporate profitability, particularly in China. Policies currently supporting Chinese growth are actually increasing structural imbalances.
We see value in EM currencies such as the Mexican peso. We generally favor EM local currency debt (especially in Brazil and Indonesia) over U.S. dollar debt. EM central bank rate cuts amid lower inflation should support many local rates markets. In equities we like India, given a nearing peak in the bad loan cycle, Mexico on structural reforms, and China based on near-term growth prospects.
|April 27||Federal Open Market Committee (FOMC) meeting and rate announcement|
|April 28||First-quarter U.S. gross domestic product (GDP), Bank of Japan (BoJ) statement on monetary policy|
|April 29||U.S. Employment Cost Index, Eurozone Consumer Price Index (CPI)|
|April 30||China official PMI data|
U.S. growth has been just right: strong enough to moderate global slowdown concerns, yet not so strong that it raises expectations of rapid Fed rate increases and dollar appreciation. This week may provide clues about how long U.S. growth and monetary policy will remain in this sweet spot for EM assets. We don’t expect the Fed to raise rates this week, but the central bank’s comments may shed some light on whether we’ll still see one or two rate increases this year. If the U.S. first-quarter GDP report comes in stronger than expected, the Fed may not be able to remain on hold much longer.
Elsewhere, expectations for further policy change from the BoJ have been increasing given recent yen strength. Official China PMI data will likely show continued improvement, confirming the EM sweet spot can continue in the near term.
- Crude prices rose to a five-month high, as markets shrugged off a failure in Doha by the world’s largest producers to freeze production levels – and looked ahead to the prospect of a more balanced market.
- U.S. quarterly earnings generally surprised to the upside, supporting the equity rally. The U.S. Dollar Index (DXY) briefly retested a six-month low.
- EM assets had a strong week. Argentina attracted strong demand for a $16.5 billion bond sale.
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