“What to do when emerging markets diverge?”

Salman Ahmed (pictured), global chief strategist at Lombard Odier Investment Managers arges that it might be time for investors to increase their exposure to emerging markets. 

We believe in a world of widespread disinflation / deflation and easy central bank policies, investors will be forced to look for increased yield. Indeed, we think that the incidence of low rates in advanced economies will push investors to re-assess their exposure to emerging markets.

In our view, there are three main challenges facing emerging markets: the Fed hiking cycle, China led slowdown and a wildcard factor of increasing geopolitical risk.

Over recent years, the fear of a Fed rate hike has put emerging markets under increased pressure and if the Fed were to adopt a more hawkish stance going forward, emerging market countries with more vulnerable fundamentals such as Turkey, South Africa and Brazil would be most exposed. However, this is not our base case scenario and we believe that Fed policy from here on in, will remain cautious and benign.

Within China, our view is that it will go through a sustained and prolonged structural slowdown in growth given overcapacity and heavy debt burden issues which is likely to lead to further monetary and fiscal easing. However, financial meltdown risk remains contained given the range of policy options available to the authorities.

Despite the sharp pressure and terms of trade shocks we have seen over recent years, a number of emerging market economies have improved their current account balances and are now running them at more sustainable levels. In a number of emerging market countries there are strong signs that valuations are diverging from where the nominal exchange rates are, leading to increased indications of undervaluation.

Against this backdrop, we have to consider that the “emerging market” label is fast becoming irrelevant. There is now a great deal of differentiation between the constituents. With each country exposed to different growth cycles, their dynamics are moving in very different directions. For example, the current world of low commodity prices is having a very different impact on commodity importers such as India versus commodity exporters such as Brazil.

Furthermore, India is a major beneficiary of the current global shift, it has gone through a reduction in inflation and improved fiscal balance, with recent data even better than expected. Their current account has improved and their public debt levels have reduced. With this in mind, we strongly believe that if we are to consider accessing this risk premia, we need to take each country’s fundamentals into account when building portfolios.

In addition to improving fundamentals, given the current climate of negative interest rates in major economic regions and sustained low interest rates off the back of global disinflation, there is a strong yield differential being offered by emerging markets; now in excess of 7% versus Germany and Japan and around 5.5% versus the US.

In summary, given these yield differentials, prolonged low global inflation, continued central bank easing and increased valuation support  we believe that the EM asset class deserves a rethink. That said, we strongly believe that harnessing underlying fundamentals is key to building a quality-based, diversified portfolio in order to access this attractive but still quite risky risk premia.

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