The road ahead may be bumpy for emerging markets, as growth eases in China and the Federal Reserve normalizes policy in the U.S. Yet we see opportunities in a variety of emerging markets and across asset classes – sovereigns, corporates, local interest rates and even currencies.
In the following interview, Michael Gomez, head of emerging markets (EM) portfolio management, discusses these opportunities, as well as investment risks and our views on growth across EM. He shares insights from last month’s Cyclical Forum, in which PIMCO’s global investment professionals gathered in Newport Beach to discuss and debate our global outlook for the next six to 12 months.
Q: What is PIMCO’s outlook for emerging markets in the year ahead?
Gomez: When forecasting growth and inflation for EM, it is always important to consider what is happening in developed markets given the linkages through the trade sector, capital flows and markets. During our most recent Cyclical Forum, we concluded that growth among developed markets is likely to diverge in the year ahead. We expect sustained growth in the U.S. with the balance of risks tilted to the upside, we reduced our expectations for eurozone growth, and while we expect some improvement from recent weakness in Japan, growth in both Japan and China remains a bit less certain given the heavy reliance on future policies.
The level of support from developed market monetary policies is also set to diverge. The Federal Reserve will likely begin to normalize policy rates over the cyclical horizon, while the European Central Bank and the Bank of Japan will need to deploy additional easing measures.
These same trends – increasing growth and policy dispersion – will also be borne out in emerging markets over the next 12 months. For Brazil, Russia, India and Mexico (BRIM), we see a modest slowing of growth to a range of 1.5%–2.5% – but the details behind the slower growth are of utmost importance when deciding how to invest. For Brazil, we expect the recent sluggish growth trend (under 2%) to continue given the policy imbalances and low rate of investment. In Russia, we expect Western sanctions and retaliatory import bans to push the country into recession. India and Mexico, on the other hand, both have higher sustained growth trajectories, and we expect them to benefit from more constructive political environments, as well as recent or impending structural reforms.
Q: Could you tell us more about PIMCO’s views on Brazil and how the election might affect the outlook?
Gomez: Brazil’s economy has been struggling with slowing growth and “sticky” inflation. What we mean is that despite the slower growth and the Central Bank of Brazil’s efforts to reduce inflation with higher policy rates, inflation at 6.75% has once again breached the top of the bank’s target range (6.5%). Part of the problem is an asymmetry in Brazil’s macroeconomic policies: An overly easy fiscal/quasi-fiscal stance (due in part to state-directed lending programs) must be offset by tighter monetary policies than would otherwise be required. As a result, Brazil has some of the highest interest rates – both nominal and real – in the world, which provides an opportunity for investors. We continue to see good relative value in Brazil versus its peers.
Brazil’s presidential election this month comes at the end of a very busy electoral calendar in EM. Forty-three emerging market countries, representing more than a third of the world’s population, were scheduled for presidential or parliamentary elections in 2014. Historically, elections have been associated with volatility for EM countries, but this year they have predominantly yielded market-friendly outcomes, which will hopefully make 2015 a year of structural reforms in EM. Here we would point to the sweeping win of Narendra Modi’s BJP party in India: The reformist party and its allies now have the largest majority in government since 1984.
Brazil’s election remains incredibly difficult to call. The market is paying particular attention because it could spark a significant restructuring of the policy mix, but the ultimate path forward – and the pace of change – will not come into focus until after the election. Regardless of the outcome, we expect the next four years will be marked by some shift in policies, with a better mix of fiscal and monetary policy ahead. So we are basing our positions on fundamental analysis and relative value – not on predicting election results.
Q: And what about China? Could expectations for slower growth there derail the broader EM outlook?
Gomez: Our outlook for China has moderated somewhat, and the consensus has also moved toward our slower-growth view. That said, we are not expecting a hard landing – the type that might produce widespread contagion among emerging markets. We are focusing our attention on trade and financial linkages and how the ripple effects of a slower China might unfold. For trade flows, Australia, South Korea and Chile seem the most vulnerable given that 25%–35% of their exports are destined for China. But it’s also important to look at the degree of export reliance for each country’s growth model. For example, Korea scores poorly in this respect – more than 40% of its GDP comes from goods exports and 26% of those are destined for China. Brazil shows a much better dynamic: Twenty percent of its goods exports go to China, but exports account for just 11% of GDP. We also consider the varying impact across EM of lower commodity prices associated with slower growth in China, with the terms of trade improving for some and worsening for others. And currency dynamics in the region are important, especially if China begins to resist nominal appreciation of the yuan.
Q: Where is PIMCO finding value in EM?
Gomez: Generally speaking, the macro environment looks less supportive in the period ahead as some developed market central banks – primarily the Fed – move toward a less accommodative policy. The initial adjustment may prove challenging for certain emerging markets and a period of rising rates may be a headwind for some assets. As a result, we are generally running shorter durations and, given the likely strength of the U.S. dollar, lower currency exposures.
Nonetheless, we are finding attractive opportunities. For example, we are focusing on local rates in countries where real yields are attractive, growth is softer and central banks are inclined to hold or even cut policy rates. Our overweights to Brazil and Poland fit into this bucket. In countries with stronger growth profiles or a focus on reforms to boost the private sector, we favor external debt, including corporate bonds, and select currencies – both of which could benefit from increases in capital flows as reforms are implemented. More broadly, we have been overweight Latin America, where policies are supportive, and underweight Eastern Europe, where growth has been constrained. In Asia, our underweights embed a relative-value view, considering many Asian assets are expensive relative to their peers.
Lastly, we have been adjusting our positions more dynamically in response to country-specific developments and dislocations. The propensity for overshoots is high in the current environment, and we constantly monitor markets for opportunities to add value through tactical positioning.
Q: What about risks? Are there areas of EM you are avoiding?
Gomez: We are constantly evaluating and reevaluating headline risks, fundamental or downgrade risks and outright default risks. In EM, risks have historically revolved around external imbalances and politics, and we continue to focus a great deal on those. We tend to underweight countries that struggle to rein in large current account deficits or rely on unstable sources of external funding and those with large currency mismatches in their banking systems. Turkey and Hungary have typically fallen into those categories. There are, however, times when investors are well compensated for those risks, so I would highlight the need to constantly evaluate relative value and be prepared to take tactical positions if warranted.
Political risks are more difficult to evaluate because they are inherently qualitative assessments. That’s where we are able to rely heavily on our analysts and portfolio managers in the regions, who know the policymakers and company management teams. Our ongoing dialogues can help assess risks as they evolve over time, so we can evaluate whether our clients are adequately compensated for the potential volatility. This would be particularly true in Argentina and Venezuela, but also in Hungary and Thailand, where political leadership has been a source of market uncertainty in the past.
Q: PIMCO’s cyclical outlook appears increasingly focused on global opportunities. Are EM opportunities being deployed more broadly across PIMCO’s strategies?
Gomez: Yes, we are investing in EM across a broad array of mandates. The global backdrop of persistently low yields in many developed markets with the potential for an uptick in U.S. rates on the cyclical horizon has led many strategies to focus on EM to enhance returns and help protect against an eventual increase in U.S. rates. Positions in Brazil, given its high real yields, are widely deployed, but other EM assets are also favored depending on the strategy. Mexico, given its stable politics, successful reform agenda and steep yield curve, is also a favorite – whether it’s the yield advantage of Mexican T-bills or the currency. Indeed, while we may have less aggregate currency risk in the face of a stronger U.S. dollar, funding EM currency positions in euro or yen has been profitable and we would look for more gains ahead. For example, several PIMCO strategies have found value in the Mexican peso, Indian rupee or Malaysian ringgit against developed world currencies. And finally, given our extensive analyst coverage across global credit, many portfolios have positions in EM banks, consumer goods producers and energy and pipeline companies.