Last October in this column, we identified the signposts of stabilization that we would look for before becoming comfortable investing more fully in the emerging-markets debt sector. By early this year, those criteria had largely been met. Indeed, we called an end to the three-year bear market for emerging-markets debt in February, when we saw three headwinds subsiding: U.S. dollar strength, the sudden decline in commodities markets and the uncertainty around China’s growth prospects and foreign exchange policy. These headwinds actually turned to tailwinds and boosted prices for emerging-markets debt.
The next stage — a recovery in key economies and a rebound in portfolio flows — is happening now. In our view at BlackRock, both trajectories have legs and could support the asset class in the year ahead.
We are starting to see a more fundamental recovery in several emerging-markets economies that had been hit hard by the recent downturn, including China, Brazil and Russia. These economic green shoots, when combined with stronger technical factors, have driven both hard and local currency–denominated debt in these markets to double-digit returns as of the end of July. This rally is nowhere near exhausted, in our view. Near-term political risks, such as the recent Brexit vote in the U.K., appear to regionally contained. So, as long as we also see continued recovery and stimulus in China and Brent oil close to $45 a barrel, we think emerging-markets debt is likely to enter into the next stage of recovery.
This next phase is likely to be characterized by capital inflows into the asset class after years of outflows (see chart). The flows are driven by investors searching for meaningful carry in a world in which yield is extremely scarce. Many investors are also covering significant underweight positions in emerging-markets debt holdings. At the same time, to the degree that growth remains anemic in the developed world and emerging markets continue to appear on an upswing, there will also be good reasons for investors to make this transition. Encouragingly, the Institute of International Finance’s emerging-markets growth tracker suggests that economic activity bottomed in the fourth quarter of 2015 and has recovered decidedly since then. Also, since early 2016, the emerging-markets purchasing managers’ index results appear to have bottomed. The International Monetary Fund estimates that growth in emerging markets is likely to accelerate from 4.2 percent this year to 4.7 percent in 2017.
Despite these supportive technical and fundamental factors for emerging-markets debt, is it possible that the global rate outlook might derail the recovery in those economies? We regard that as unlikely.
First, the uncertainties surrounding the ultimate economic impact from the Brexit vote, as well as troubled banks in Italy, and slow regional growth are likely to keep both the Bank of England and the European Central Bank on quite dovish paths for some time. Moreover, it is largely the negative yields in European markets, and in Japan, that are causing the structural reallocations of capital toward higher-yielding parts of global markets. And although it is possible that the Federal Reserve may hike rates in 2016, that’s looking less likely, as the U.S. economy has displayed very slow growth in the year’s first half. All this should provide a supportive global rates backdrop for emerging-markets debt for at least the rest of 2016.
Less uncertainty over China’s growth and a bottoming out in oil prices were vital structural changes, in our view, for putting emerging-markets debt on a more solid path. Still, some may wonder, Has the improvement in these areas been enough? In our estimation, merely seeing some stability in the price of oil and in China’s economic expansion is sufficient for investors to be more confident in their ability to capture the coupon opportunities that are available in emerging-markets debt. Indeed, our analysis suggests that commodity prices and stronger growth expectations only explain about a third of the spread tightening witnessed in hard currency sovereign bonds so far this year, with the remainder largely the result of previous deviations from fundamentals.
Moreover, we think continuing capital flows into the sector are likely to be the primary driver of performance in the balance of the year. In a world dominated by monetary policy distortions, meager developed-markets growth and tremendous amounts of capital seeking higher yields, we think emerging-markets debt is well suited to receive additional capital flows. Added to that view are the facts that emerging-markets economies appear to be turning the corner, and developed-markets central banks remain remarkably accommodative. In the end, although the sector has struggled in recent years, we are confident that early 2016 marked a turning point for the asset class, even if selectivity and country-specific risks must be navigated with care.
Pablo Goldberg is a portfolio manager and senior strategist with BlackRock’s emerging-markets debt team in New York.
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