With emerging markets (EMs) experiencing episodic volatility and underperformance in recent years, analysts have started to question the wisdom of long-term investment in these regions. However, as investors find surging returns for EM investments in 2016, is the asset class starting to show sustainable value?
In a market commentary titled A Constructive Case for Emerging Markets
, experts at PIMCO Canada explain reasons to believe that the time is right to invest in EMs, “but with appreciation for the current macro risks and a strong emphasis on bottom-up analysis to avoid capital losses”.
Citing increasing returns seen in selected JP Morgan emerging market indices, the piece discusses several factors that may contribute to their current success.
EM fundamentals are one piece of the puzzle: reductions in USD strength, stabilization of commodities, and a bumpy but mildly positive outlook for China present external tailwinds for EMs to ride on. EM currency depreciation, improved competitiveness, and increased export volumes are also leading to significant adjustments in EM external balances.
The commentary also commends conservative changes in EM economic policies: “In reaction to [deteriorating fiscal and current account balances], emerging market policies have started to adjust: safeguarding reserves by allowing more currency flexibility, retracting expensive government subsidies, cutting other expenditures to reduce fiscal deficits and using more conservative macro and commodity price inputs in budget assumptions.”
Increasing stability and resilience are a big plus. Political and geopolitical tensions in EMs seem to be receding among high-profile issuers, with several business-friendly governments coming into power, including in Argentina, India and Peru. EMs are also showing remarkable resilience to recent exogenous shocks, with various policy tools and domestic market reinforcements providing a strong countercyclical buffer.
While the commentary sees the best for EMs in the present, it does not discount external threats in the future. “A renewed bout of global risk aversion would likely pose headwinds for the emerging asset class, which continues to trade with a heightened beta to global markets. Further declines in commodities, an increase in volatility and uncertainty related to China, or an overly hawkish turn by the Fed could all easily shift the cyclical outlook for emerging markets.”
There’s also the question of whether EMs could sabotage their own success over the long term. “The ability of emerging economies to effectively and politically address structural challenges to unleash long-run growth is yet to be fully tested… Moreover, it’s not clear to what extent [incumbent administrations] have the incentives to tackle these issues as they balance the near-term costs against the longer-term benefits.”
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