The strong performance by both emerging market (EM) bonds and EM equities so far in 2017 has caused some investors to question whether the rally can possibly have further to run. The concerns appear valid; EM assets are now more widely owned and valuations are certainly not what they were at the beginning of 2016.
In our view, however, the rally has further to go. The macroeconomic environment for EM assets could remain positive for another two years, driven by strengthening growth in EM economies. Central to our positive view are the developments we see in the EM domestic credit cycle.
Credit is crucial to the growth outlook, but in general poorly understood by the market. The market tends to focus on credit growth, and tends to be positive on the growth outlook when credit growth is high. At present, credit growth in EM is low and, as a result, EM domestic demand growth is expected to remain weak. However, what really drives the economic cycle is not whether credit growth is high or low, but whether it is rising or falling. This change in credit growth is known as the ‘credit impulse’.
The credit impulse quickens
From 2011 to mid-2016 credit growth in EM was falling, the credit impulse was negative and GDP growth was weak. Now credit growth is stabilising. The consensus remains cautious on EM growth because credit growth is very low, but because it has stabilised, the credit impulse is improving. As a result we expect EM GDP growth to spring a positive surprise and strengthen to 4% in Q3.
This supportive macro environment can be sustained for some time. Credit growth in EM is currently running at around 5%, which is much lower than nominal GDP growth at 10%. The EM debt ratio is falling and this is unlikely to be sustained. Over time we would expect credit growth to rise towards 10%, and this could provide a tailwind to EM economic activity that could continue for at least the next two years.
Since the start of 2016 we have seen signs of the EM rebound in strong car-sales growth and an increase in PMI levels. Now, however, it is even reflected in the official GDP numbers, where EM growth is rising both in absolute terms and relative to developed markets (DM).
The two countries where these trends are most obvious are Brazil and Russia. In Brazil, credit growth fell to -5% in 2016, but as it has started to stabilise, the credit impulse has picked up. Brazil has experienced two quarters of positive GDP growth already, and we expect the second half of the year to be even better. This process is more advanced in Russia, where GDP growth hit 1% quarter on quarter in Q2.
The growth trends are crucial for the market. This risk to EM assets frequently stems from FX but, when growth is strong, EM FX tends to perform well. This leaves investors able to benefit from the attractive yields EM bonds continue to offer. EM assets also tend to outperform their DM counterparts when the growth differential widens. In our view, stronger growth means that EM assets are attractive in both absolute and relative terms.
There are still risks to the outlook, and these would include a hard landing in China, negative trade- policy surprises from the US, or a period of US dollar strength. In our view, however, these risks are well understood and adequately priced in the market. What is less well understood is the impact of the credit cycle, and we believe the positive growth surprises can drive a rally in EM assets for a while to come.
Michael Biggs, investment manager, emerging markets fixed income at GAM