Viewpoints

Shifting Realities and Opportunities in Emerging Markets

EM have become more resilient but risks remain.

One truism spanning the last three decades has been that emerging markets are a leveraged play on global growth – often outperforming when developed markets (DM) are growing but susceptible to sharp downturns when DM conditions are less favorable.

While this trend remains intact, understanding what has changed in the wake of developed market financial crises and the shift in the geopolitical landscape in the past few years is central to defining the emerging markets (EM) investment opportunity set going forward.

The new reality is that many emerging economies have become more resilient for a host of reasons, and they no longer simply ride on the coattails of developed market growth and policies. However, these positive developments are juxtaposed against a fresh set of challenges, namely increasingly procyclical liquidity provision by market makers, a rising propensity for populist policies and a temptation to rely on currency depreciation as a substitute for much-needed structural reforms.

Weighing up these new realities with the sell-off in EM assets so far this year, we think value and risks are now better aligned. However, the long list of risks facing EM still argues for a highly differentiated stance, as market illiquidity has the capacity to magnify the impact of any shock on prices.

The long-term case for emerging markets

In addition to higher yields than their DM counterparts, three trends underpin the secular case for investing in emerging markets across global business cycles.

  • EM economies have climbed up the development and ratings scales over the past few decades, lessening significantly their dependence on foreign borrowing.
  • Most have moved to floating exchange rates, which serve as buffers against external financing shocks. As a result, growth in these countries is more insulated from shocks such as an unanticipated tightening in U.S. monetary policy.
  • And crucially, with many having established track records as credible inflation targeters, most EM central banks no longer have to embark on procyclical monetary policy tightening in the face of large exchange rate depreciations. Domestic bond markets are accordingly better insulated, which in turn gives many governments recourse to counter-cyclical fiscal policies to stabilize growth and preserve debt payment capacity.

After 30 months of Federal Reserve tightening and 18 months of the administration of U.S. President Donald J. Trump, we are also encouraged by several recent developments.

First, the glacial pace of monetary policy normalization in the developed economies looks likely to continue due to aging demographics, high debt levels and weak productivity growth. Low equilibrium interest rates are an important anchor for EM local and external debt prices. So is the dearth of inflation pressure globally despite ongoing labor market improvements.

Second, having typically been “condition takers,” emerging markets are closer to being condition makers than at any point in modern times. In particular, this reflects China’s rising share of the global economy ‒ witness the reverberations across global markets from China’s periodic bouts of growth uncertainty over the past few years. Going forward, weak EM growth is likely to influence policy decisions by developed economies.

And third, the sensitivity of EM economic growth to U.S. interest rates and the dollar should lessen given lower external borrowing needs, the relative lack of external borrowing in dollars specifically, and reduced dependence on commodity exports. While Argentina and Turkey are noteworthy exceptions, most major EM economies have been substantially liberated from “original sin” ‒ their governments’ inability to borrow in their own currency.

The complexities of the new EM reality

These constructive trends have nuances and repercussions that we think must also be factored into investment decisions.

While liberation from original sin mitigates the need to tighten policy pro-cyclically into externally driven shocks, it also means that the burden of any requisite adjustments will fall disproportionately on exchange rates rather than domestic interest rates. As a result, exchange rate depreciation, particularly in countries with credible inflation-targeting regimes, acts as a crutch for growth.

Moreover, weaker potential growth, the counterpart to lower equilibrium interest rates, has created fertile ground for populism. Countries lacking robust institutions are more likely to adopt populist policies that ultimately hinder growth. So while risks may be lower on average for emerging markets, this left-tail risk remains high.

Meanwhile, though the less-liquid nature of emerging markets has always demanded extra care in scaling positions, the liquidity risk premium for EM assets may be more procyclical than in the past. Regulatory changes have reduced the intermediation capacity of traditional liquidity providers, while new, computer-driven intermediaries with negligible capital buffers are prone to withdraw from the market when volatility rises.

Finally, the success of emerging markets in transitioning to floating exchange rates, combined with the low-growth environment, has indirectly led to a proliferation of nationalist, protectionist policies in the developed economies. When exchange rates bear the burden of domestic macro adjustments in a higher global growth environment, reslicing a large growth pie through currency movements is less perceptible.

But with growth potential now lower, political sensitivities to exchange-rate-driven adjustments are higher. This raises the risk of a feedback loop between EM currency depreciations and DM political responses, which include tariffs and other trade measures designed to protect their shares of a shrunken pie. This loop is difficult to break because EM currencies typically weaken as growth is threatened.

The bottom line

From an investment perspective, we can draw several conclusions relevant to both short- and long-term horizons.

  1. Traditional EM risks, defined by vulnerability to external financing shocks and volatility of GDP growth, have gone down. So has the traditional threat to emerging markets: sharp, unanticipated changes in developed economy monetary policies.
  2. Despite lower potential growth and lower equilibrium interest rates in developed economies, absolute returns on average for emerging markets may be no lower than in the past.
  3. Liquidity disruptions are likely to occur more frequently, requiring careful attention to the size of illiquid exposures in periods of low volatility. Active managers have the ability to position assets to exploit valuation discounts following from liquidity-driven overshoots.
  4. Lower potential growth means greater propensity for populist outcomes. Higher spreads will likely need to compensate investors in part for this risk.
  5. The EM asset hierarchy has been flipped on its head. In the past, EM countries defended exchange rate pegs. Stress was borne first by local interest rates rising sharply and then through wider external debt spreads as currency pegs came under pressure. Now, currencies are the primary buffer, which mitigates the fallout on EM debt. However, this may imply larger, but less disruptive, currency adjustments than in the past.

While we think EM currencies are now attractively valued, investors need to scale their exposures carefully given the persistent uncertainties around U.S. trade and fiscal policies. But the more important point is that currencies are working to insulate EM growth. Ultimately, sustained growth is the best immunization against populism.

We see the latest sell-off in external and local EM debt as having rebalanced valuations and near-term risks. We believe any contagion from the weaker credits to the stronger credits in emerging markets should offer selective buying opportunities for the remainder of this year and into 2019.

For more on emerging markets, please see the Viewpoint, Investing in China: Evolving Opportunities.

Read now
The Author

Gene Frieda

Global Strategist

View Profile

Latest Insights

Related

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.