PIMCO professionals recently convened at our Newport Beach headquarters to discuss the global outlook and its implications for asset prices. Our cyclical baseline (six to 12 months) foresees additional slowing ahead, making the global economy vulnerable to additional shocks (see Window of Weakness for more details).
Emerging markets (EM) are caught between these rising risks of a global slowdown and the more favorable interest rate backdrop in developed economies. Still under repair after a series of negative shocks over the past eight years, most EM economies exhibit more early cycle characteristics relative to the mature stage of the expansion in developed markets (DM). The corollaries to weaker growth are improving current account balances that tend to insulate EM economies from external shocks. Weak growth may also foster populism and heterodox economic policies, highlighting the importance of governance scoring as a differentiating factor within such a large group of countries.
Weighing all these factors, we see greater investment opportunities in EM local duration and EM credit in this period of transition for global markets.
Our approach to EM investing
At PIMCO, we believe that flexible strategies are key to investors enjoying the full benefits of diversified EM benchmarks and mitigating positive cross-asset correlations.
Our asset allocation decisions in multi-asset emerging markets portfolios have typically revolved around contrasting “balance sheet” assets that are largely driven by sovereign debt levels and dynamics, and “income statement” assets that are more sensitive to nominal growth considerations (see Figure 1). In recent years, our bias has been toward more defensive balance sheet assets, most notably EM external credit and more recently EM local duration, relative to growth-sensitive assets like EM currencies (foreign exchange or FX) and EM equities.
Our bias toward EM local duration reflects how, relative to past cycles, EM monetary policies are generally far less constrained by currency depreciation, reflecting reduced FX pass-through to inflation and lower foreign-currency-denominated debt burdens. Importantly, the ability of EM central banks to “follow the Fed” toward looser policies should help strengthen EM balance sheets.
Given the uncertain macro backdrop and the vulnerability of growth rates (already near stall speed) to additional shocks, we believe it is not yet time to shift away from a more defensive stance. Our overweights in local duration and credit are designed to offer attractive carry in a low core rate environment and to hedge our portfolios from additional downside risks to growth.
We recognize, however, that the relative cheapening in more growth-exposed assets suggests that pricing of a weak global cycle is somewhat advanced, particularly in currencies. To account for better valuations and the possibility of a soft landing, we have selectively increased our EM FX positions in EM multi-asset portfolios to bring the overall currency exposure to neutral. (Note that in this paper we discuss positioning in an EM multi-asset portfolio – see Figure 2 – while in the Asset Allocation Outlook Midyear Update, we looked at positioning in multi-asset portfolios of DM and EM assets.)
Indeed, EM FX is definitely the asset to watch more closely going forward, given its potential to act as a signal for a turn in the global economic cycle closer to recovery or to recession. We favor staying liquid in our portfolios to prepare for potential changes ahead. We remain underweight EM equities.
Local duration, high appeal
We believe EM local duration (i.e., sovereign debt denominated in the local currency) offers the best risk-adjusted return potential in an environment where a soft landing and recession are plausible outcomes. Economic slack is keeping inflationary pressures in check, allowing many EM central banks to ease monetary policy countercyclically. We think EM local duration positions will serve as good diversifiers for global rates mandates; specifically we focus on countries with one or more of the following characteristics:
- Lower-yielding countries where steep curves offer good real carry and better return prospects versus DM curves offering negative yields and inverted curves. Examples include Hungary, Peru, and Israel.
- Mid-yielding countries that, thanks to stable policymaking, have an ability to lean successfully against global growth headwinds. For countries such as China, local duration is likely to remain well supported even if we see a modest increase in U.S. Treasury yields.
- Higher-yielding countries with large negative output gaps where we find currencies are already cheap (reflected in much improved external balances). Mexico, Brazil, and Russia fall into this category.
EM external debt is also compelling
We see value in EM external debt, and it remains a core overweight in our EM multi-asset portfolios. We prefer the liquidity profile of sovereigns but continue to appreciate the diversification benefits that corporates offer given shorter duration and better ratings profiles.
- Sovereigns: We favor a basket of names that we believe are good proxies for EM external risk and have the potential to outperform given stable credit attributes. With valuations in the investment grade (IG) segment of the benchmark looking tight, we have tilted our portfolios toward high yield names given our belief that the rates environment globally will remain supportive into 2020. That said, we are monitoring risks to core rates closely. Some of the countries we favor include Indonesia, Romania, Ukraine, Brazil, and the Dominican Republic. Contagion from Argentina has been limited thus far, but we have the flexibility to engage in opportunities should dislocations materialize. Finally, we think sovereigns will remain a natural destination for crossover investors looking to diversify away from ultra-low rates and rich credit valuations in developed markets.
- Corporates: EM corporate fundamentals continue to improve, boosting both the stand-alone profile of the asset class and its value as a diversifier to EM sovereign portfolios. Below-trend growth has led many firms to reduce capital expenditures and prioritize free cash flow to reduce their balance sheet leverage while terming out their liabilities. Gross and net leverage metrics are now at multi-year lows, and financial liquidity is a more remote concern. These positive trends in fundamentals have been more visible in Latin America, Central and Eastern Europe, the Middle East, and Africa, where, in aggregate, net issuance has been negative for the past two years. Asia, on the other hand, continues to see positive net borrowing, with Chinese high yield making a significant contribution. We expect valuations for EM corporates to remain well supported given the higher proportion of investment grade names, ample credit spread, and lower duration (4.5 years) of the BBB- rated J.P. Morgan Corporate Emerging Markets Bond Index Diversified (CEMBI) benchmark. Commodity prices and weaker global growth overall are risks worth monitoring, but we feel these risks should be contained by a good initial starting position on EM credit metrics.
EM FX at low levels
On average, EM currencies are near their cheapest levels in two decades and appear well priced for a global growth slowdown. Resilience to global uncertainties is driving atypically robust external positions. Potential returns have improved, and hence we recently moved our FX position to neutral from a modest underweight.
In the current context of weakening growth, broad U.S. dollar overvaluation, and DM central bank policy easing, we estimate EM currencies could deliver good carry at a minimum, and potentially much more if the dollar finally turns weaker. The trade-weighted dollar is rich and increasingly vulnerable to a soft landing or an alleviation of global trade uncertainty.
For now, we prefer a diversified basket of EM currencies given what we see as better valuations, but with low scaling to account for recession risks and uncertainties around trade.
Our conviction level to add to EM FX positions would rise on further evidence that trade uncertainty has been better absorbed in a cyclical sense. At that point, our expectation would be that smaller, more open economies would have greater scope to rebound relative to the U.S. and that the dollar would accordingly shift from its recent sideways movement toward a more sustained depreciation trend.
EM equities face challenges
The cyclical backdrop remains challenging for earnings growth fundamentals and equity valuations in emerging markets. We expect earnings downgrades to continue to weigh on EM equities. The earnings outlook combined with forward valuations slightly above 10-year averages make it hard to justify a more positive stance on EM equities.
In addition, the high share of cyclical sectors and those exposed to Chinese growth also make EM equity benchmarks more vulnerable to the ebbs and flows of trade disputes and to China’s reaction function, which looks muddied at present. EM Asia countries comprise close to 72% of the MSCI Emerging Markets benchmark index.
Forward-looking growth concerns also affect operating leverage and capital expenditures. These trends should favor bondholders, as companies continue to prioritize deleveraging their balance sheets as opposed to engaging in growth initiatives.
Improving sentiment on any reprieve of trade tensions could boost EM equities. For a broader reassessment of our underweight stance, we would like to see first a sustainable rebound in new orders globally within the purchasing managers’ index (PMI) along with a visible turn in the dollar cycle.
We see emerging markets potentially approaching a pivot point over the coming six months toward recovery or weaker growth. EM rates are the top pick in our EM multi-asset portfolios. We are staying liquid in our portfolios to prepare for potential opportunities ahead. To this end, we believe EM FX is definitely the asset class to watch more closely going forward, given its potential to act as a signal for a turn in the global cycle that could favor greater allocation toward more growth-sensitive assets.