Photographer: Dario Pignatelli/Bloomberg

Storming or Storm-Bound? Here's an Emerging-Market Reality Check

Updated on
  • ‘We all enjoyed the party’ but this may be the last leg: Deka
  • EM currency and bond indexes have reached three-year highs

Nothing has been able to silence the roar of emerging markets this year, be it Kim Jong-Un’s missiles, President Donald Trump’s protectionist rhetoric or a host of domestic political ructions from Brazil to South Africa and Turkey.

Instead, investors have focused on economies supported by slowing inflation, a recent recovery in commodity prices and the comfort of watching central banks conducting policy by more conventional methods than their developed-nation counterparts. The MSCI EM Currency Index and the Bloomberg Barclays index of emerging-market local-currency government bonds both reached three-year highs this month, while a gauge of developing-nation equities is close to its highest since 2011.

And now that the Federal Reserve has laid out a tapering game plan likely to drive down longer-maturity U.S. Treasuries, the bulls are taking new heart, betting the rally’s just getting started.

For others, it’s getting perilously near to closing time.

“We all enjoyed the party, but this may be its last leg and there maybe more volatility in the year-end,” said Peter Schottmueller, the head of asset allocation at Deka Investment GmbH in Frankfurt, who helps manage the equivalent of $7.8 billion. “The market is very myopic and very short-term focused.’’

Below are five graphics showcasing the state of emerging markets as investors consider whether to jump into the festivities or make an early exit.

Corporate borrowing has outstripped economic growth over the five years through 2016, according to the Bank for International Settlements. That’s raised questions about how long it can continue as central banks in developed nations prepare to pare back quantitative easing, according to Toru Nishihama, a Tokyo-based emerging-market economist at Dai-ichi Life Research Institute Inc.

To get a sense of the resilience of developing-market stocks, there are few better places to look than Brazil, where the economy is emerging from its deepest recession on record. A corruption scandal hampering President Michel Temer’s attempts to drive through pension reforms has failed to derail a rally that drove stocks to an all-time high. Bank of America Merrill Lynch this month raised its target for the Ibovespa, seeing ample room for more exposure to Brazilian stocks in the local mutual-fund industry.

Emerging economies expanded 4.4 percent in 2016, almost half of the rate of a decade ago, when the Fed was in its last year of a cycle of interest-rate increases. “There remains a gap between the growth rate of emerging economies and developed countries as well as returns from investment, and investors will continue to pour funds into emerging markets,” Dai-ichi’s Nishihama said. “However, from here, not all emerging-market investments are rosy, and investors may become more selective in which country or countries to invest.”

Africa typifies the bullishness. Eurobond issuance from African governments is already at a full-year record of $14.6 billion, despite a slew of ratings downgrades, including for South Africa and Namibia, that has left the continent without a single nation that is fully investment grade. Moreover, Mozambique -- which defaulted in January and hasn’t even started restructuring talks with investors -- has the best-performing bonds in emerging markets this year after Belize, clocking up a 31 percent gain.

All 21 global emerging currencies have had positive carry-trade returns this year amid low volatility. Fundamentals remain solid, such as real yields, external balances and growth dynamics, and volatility compression reinforces the carry trade, Jason Daw, the Singapore-based head of emerging-markets strategy at Societe Generale SA, wrote in note dated Sept. 21. Any developed market-policy induced weakness are buying opportunities, he wrote, adding that he was maintaining “short-dollar characteristics” in his foreign-exchange portfolio.

— With assistance by Yumi Teso, Hannah Dormido, Selcuk Gokoluk, Paul Wallace, Aline Oyamada, and Masaki Kondo

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