24th January 2014 by Nick Gartside
How trends shift. It wasn’t so long ago that all the rage was about how developed and emerging markets were re-coupling. A glance back over the last nine months shows how far fetched this now looks.
Estimates of economic growth for developed economies continue to be ratcheted higher and higher. Consensus estimates for growth one year forward for the UK and US are around 0.5% higher over the quarter. Whereas emerging economies continue to stutter. Brazil, for example, is only likely to grow by around 2.0-2.5% this year. The other divergence is in inflationary trends. Somewhat oddly, as developed market growth estimates have increased, expectations of inflation rates have fallen. Conversely, over in emerging markets, as growth expectations have fallen inflation expectations, partly driven by currency depreciation, have increased.
Self evidently, these divergences have also spilled over into market returns with emerging market assets under pressure relative to developed markets. There are, nonetheless, a couple of surprises. Perhaps the first is the performance of bonds this year. Shorting bonds remains a consensus trade and the year to date performance (up around 1%) serves to demonstrate the extent of repricing that was seen in 2013 and that fixed income is now much more of a two way market with some yield cushion. In total return terms, 2013 was as bad as 1994 with the 10yr US Treasury down around 8% on each occasion.
Secondly, at some point, emerging markets will present an irresistible valuation opportunity not just on a relative basis where the emerging market local index yields 1.5% more than high yield. But also on an absolute basis where the index yield is around 7% and individual countries like Brazil and Turkey yield 12.5% and 10% respectively. Economies do decouple, but in an increasingly globalized world it tends to be transitory. This leaves two outcomes. Emerging markets drag developed economies down, or, developed economies drag the emerging world up. Our sense is the latter. This will pressure core government bonds, but will accentuate the hunt for yield and the appeal of credit and, in time, emerging market debt.