Investors who are bullish on the emerging markets have learned — sometimes with a bit of pain — that a robust regional economy doesn’t necessarily translate into strong local equity markets.
With Europe on the verge of collapse and the American economy growing at an anemic rate of 1.8 percent in 2011, emerging markets on average experienced economic growth of 5.2 percent. Yet emerging-market equities on average underperformed the S&P 500 last year.
Don’t lose faith in the emerging markets, says the chief market strategist for institutional business at J.P. Morgan, Rebecca Patterson. In a meeting with the bank’s leading institutional investors late last week, Patterson recommended making emerging-market equities a part of any growth portfolio for the long term.
According to Patterson, emerging market growth could reaccelerate from a trough (about 4.1 percent in the fourth quarter of 2011) to what she calls a “trend-like pace” in the second half of this year. “And that’s going to be propelled primarily by easy monetary policy and less of a headwind for exporters from currencies,” she said.
Part of the issue last year was that many emerging markets experienced monetary tightening. The aggregate emerging market policy interest rate between February 2010 and the middle of 2011 rose 150 basis points, she said, compared with steady or lower rates in the developed world.
Emerging market growth, which had slowed to within a 3 percent differential with developed market growth during the second half of 2011, could ramp up by another 2 percentage points during the coming year because of monetary easing, according to J.P. Morgan. “We’d also look for emerging market-driven growth via developed-market equities that have outside exposures to fundamentally strong emerging markets. We think those sorts of strategies can also help performance relative to a broader developed-market equity benchmark,” Patterson said.
Her investment banking colleagues at J.P. Morgan say that global GDP growth will be about 2.1 percent. That’s 1 percentage point below the rate global economies have enjoyed during the last 20 years. It’s a sobering forecast, indeed: The only two years that saw GDP growth lower than 2.1 percent were 2008 and 2009.
On the domestic fixed-income side, Patterson said that markets are priced in “overly pessimistic” default and recovery rates. As of mid-December, she said, investors faced an implied default rate of some 7 percent with the recovery rate of approximately 30 percent backed out via current spreads over treasuries. “And we think defaults could rise certainly from current levels, which are about 2,” she said. “But we would not expect to move close to the implied levels without a much more serious recession or exogenous shock.”
High-yield debt won’t be immune, according to Patterson, although she recommends making such debt a part of a well-balanced portfolio. What’s more important than ever is to find investment strategies that include active portfolio managers scouring balance sheets and picking the right bonds. “We’d also say that we don’t want to chase yield by going too far out in terms of credit quality,” she said. “You know, there’s no free lunch.”
