10th December 2015
In his outlook for 2016 James Barrineau, Schroders co-head of emerging markets debt relative, explains why after a difficult 2015 he sees the issues hampering the asset class as slowly healing…
In 2015, the challenges for emerging market debt were mostly internally generated, coupled with the headwinds from a strong dollar and volatility surrounding the divergences in developed country monetary policy.
Moving into 2016, we see the internal issues for the asset class as slowly healing. Given the universally negative sentiment surrounding the asset class, an improvement in factors externally would bring a much better environment.
It’s (largely) about growth
Growth issues took precedence in 2015, especially for the major countries of Brazil, Russia, and China. For Brazil, no end to a deep recession is currently in sight, but a much weaker currency will eventually improve external accounts and competitiveness for a long, slow return to expansion.
In Russia, a favourable policy mix has mostly successfully managed the economy through the steep drop in oil prices, and there are encouraging signs that growth has seen the worst. China has been most impactful, and growth challenges will remain, but the transition to a consumer-led model is underway within the constraints of slower global growth, and we expect stable growth with low odds for a hard landing.
Outside these countries, investors have mostly ignored the fact that emerging market growth, while moderating, has been consistently better than the developed world. Latin America, outside of Venezuela and Brazil, is growing between 2.5% and 3%, while European emerging markets outside Russia are showing similar numbers. Asia ex-China and India is showing over 3% growth and India remains the star at around 7% growth.
Investors spent 2015 anticipating that the slowdown in emerging market growth would precipitate a crisis in the asset class. However, fiscal policy remained prudent across countries, monetary policy was not excessively loosened to stimulate growth, and while foreign exchange reserves declined, they were not spent in a futile attempt at stemming currency depreciation. That policy mix provides the necessary, if not sufficient, conditions for a modest recovery in overall growth in the coming year.
The macro environment will matter greatly
Negative sentiment surrounding emerging markets was also largely fuelled by global factors. The steep slide in commodity prices became correlated with negative emerging market prospects in the eyes of many investors. Even if prices only stabilise rather than recover, we expect that would feed into more stability across assets, especially currencies. Significantly lower investments for exploration should improve the odds of this scenario playing out.
But the major driver for emerging markets has been the strong dollar. Since the “taper tantrum” of May 2013, emerging market currencies have lost about 40% of their value on average. This was accompanied by liquidity into the asset class drying up, credit default swaps widening significantly, and currency volatility picking up.
Even if the Federal Reserve (Fed) pulls the trigger on a rate hike as expected in December, it is hard to argue that this has not already been well priced into markets. If the rate hiking cycle proves modest and the strong dollar simply treads water, currencies should stabilise or appreciate. That would create a small virtuous cycle, where policymakers can eventually respond to the resulting lower inflation pass-through with modestly lower rates, reserve levels would likely cease falling, and growth prospects would improve.
Asset prices reflect subdued prospects for recovery
As a consequence of the challenges surrounding the asset class, emerging market dollar spreads to US Treasuries are attractive relative to their five-year history; now about 80-90% cheaper than historically, depending upon credit rating.
Those higher spreads have allowed dollar, sovereign and corporate debt to produce about a 3% positive return this year despite ongoing fears about the asset class. Unless the Fed embarks on a surprisingly aggressive course, modest positive returns are achievable next year simply if spreads return to historical means.
For local currency bonds, the dollar will tell the tale. However, aggregate yields are near their five-year highs and investors are well compensated now for currency risks. Real exchange rates are fair-to-cheap, so any positive surprise to the global outlook would potentially make emerging market local currency investing one of the top performers across global fixed income, in our view.