2017 provided fertile ground of most asset markets, and emerging market debt was no exception. Volatility was meagre, global growth was synchronised, inflation failed to pick up, all supporting economic fundamentals across EM to continue on a strong trajectory – and we don’t expect things to be too different this year.
But as the global central banks gradually take a step back from their current monetary easing policies and the Fed starts to unwind its balance sheet at a faster pace, financial conditions will tighten— thankfully not to levels that would lead to EM sell-offs, but investors will need to remain flexible as the investment environment changes, picking sectors such as local currency debt, and high yield sovereign and corporate bonds which offer the best exposure to the economic back drop while providing attractive valuations.
Good news is that growth is expected to remain a key positive driver behind the investment case for the asset class. Major EM countries such as Brazil, Russia and South Africa are finally recovering from severe recessions in 2015-2016 and as a result total EM growth is not only forecast to increase but should also be broader-based than previously.
Importantly, while developed market growth troughed later in 2012, emerging markets continued to slow for another three years and only started to turn around in 2016. As a consequence, developed markets are entering late stages of the economic cycle, whereas emerging markets are still in mid-cycle stage. This year, EM GDP growth is expected to accelerate to 4.9% while developed market GDP growth is forecast to stall at 2.3%.
But let us not be complacent. There are challenges investors need to be wary of.
Higher inflation is on the cards for most EM countries which could cause pressures in some markets, most notably in China, India and Central Eastern Europe. While falling inflation has recently bottomed out across emerging markets, it is likely to rise from 4.2% year-on-year in 2017 to around 4.5% in 2018.
Certainly, in recent years, economists have over-estimated the inflation trajectory. While there are strong reasons to believe that there will be a non-disruptive synchronised global reflation, structural factors should continue to moderate overall inflation risks. Aside from all the mid to late cycle signs, the end of global quantitative easing policies should also play a central role. Although US balance sheet reduction alone should not be disruptive for markets, added to the Bank of Japan’s tweaking of the yield curve control and the ECB’s taper later in 2018 it is likely to create some volatility in core markets such as South Africa, Turkey, Brazil and Argentina.
There is no hiding from the fact that 2018 marks a full on political calendar, which could either spur or weaken the EM fundamental improvement story.
In Brazil, the upcoming general election poses a lot of uncertainties as corruption scandals continue to hurt the current government, which provides a favourable environment for a populist politician or an outside to step in. The importance of this vote is amplified by the need for social security and other reforms to fix a concerning fiscal outlook and put the economy on the right growth track.
Similarly, in Mexico, upcoming presidential elections in the summer look to be favourable to populist Morena candidate Andrés Manuel López Obrador (AMLO) and there are additional political risks stemming from the ongoing North American Free Trade (NAFTA) renegotiations.
While in South Africa, Cyril Ramaphosa’s win in the ANC elections in December was an encouraging sign for the markets, but a lot of Jacob Zuma’s loyalists remain in the ANC leadership, slowing any potential reform momentum. In Turkey, the situation remains uncertain and is a political risk story that will most likely continue to put investors on edge in 2018.
Investors are without a doubt faced with an environment that will have shifting economic conditions over the next year, meaning that a flexible EM strategy with a downside management bias, in order to deliver positive returns with limited risk exposure is well advised.
We feel confident that positive momentum in terms of improving fundamentals, coupled with a supportive global backdrop of solid growth and well-maintained inflation should propel positive earnings in EM debt over the coming quarters, helping weather any potential surprises in core rates, geopolitics or central bank policies.
Pierre-Yves Bareau is head of Emerging Market Debt, JPMorgan Asset Management