The author of this article says the recovery in most emerging markets seen in 2016 looks set to continue, notwithstanding some geopolitical angst.

Emerging markets have not had the happiest of times in recent years, despite a bit of recovery in 2016. Higher rates, which appear to be on the horizon in the US, will elevate the costs to emerging market borrowers of repaying debt; there have also been worries about whether US president-elect Donald Trump’s protectionist rhetoric, directed at countries such as China, will bear fruit. (China, it should be noted, has already had tariffs imposed on output such as steel by the US, including under the Obama administration.) On the flipside, global economic growth appears, if anything, to be picking up pace. So what to make of the emerging market story? Ricardo Adrogue, head of the emerging markets debt group at Barings, takes up his pen to consider events and possible trends. The editors of this news service are pleased to share these views; readers are invited to respond and can email tom.burroughes@wealthbriefing.com.

Following several years of underperformance relative to developed markets, emerging market assets staged a comeback in 2016 across both debt and equity markets. We believe conditions look favourable for this trend to continue in 2017. 

The global macroeconomic backdrop is supportive, with low but positive economic growth combined with tame inflation by historical standards. While interest rates look set to move higher in the US, we believe that emerging markets are broadly equipped to handle this. 

Prospects vary from country to country, but emerging market countries have generally improved their balance sheets in the wake of the financial crisis of 2008-2009. Growth has been slower in some regions but many countries have deleveraged and funding sources look more than sufficient to cover financing needs. 

On the fixed income side, opportunities exist across both EM sovereign and local debt as well as EM corporate debt. Local debt markets, after recovering in 2016 following three years of underperformance, may benefit from currency valuations that appear cheap by historical standards. 

Emerging market local debt
In 2016, EM currencies on the whole recovered and stabilised as many countries made meaningful fiscal adjustments. In addition, commodity prices normalised, aiding balance of payments adjustments and cushioning the effect of lower global commodity prices in commodity-exporting economies. Looking ahead to 2017, we expect to see select opportunities in EM currencies but also recognise that the performance of individual currencies could potentially vary dramatically.

Over the next year, global interest rates will likely move in different directions. As the US economy continues to gain steam, rates will likely increase, while Europe and Japan appear on track to continue their accommodative policies. On the whole, EM local interest rates continue to fall as inflation remains healthy and growth remains tepid.

Looking ahead we believe EM local debt will continue to deliver low double-digit returns over the next 12 months. Countries continue to make meaningful adjustments to their current accounts to accommodate lower commodity revenues. In the coming months and year, as these countries’ economies adjust to their new currency levels, they will likely continue to diversify and compete for export market share. 

Developed market fiscal policies will likely be expansionary in 2017, providing support for global growth. Stronger global growth—barring meaningful reversals in global trade—should in turn benefit emerging markets. Global inflation may rise but will likely remain relatively subdued over the next several years. Due to the lower inflationary pressures, we expect to see lower overall interest rates for EM local bonds, where nominal yields offer significant compensation for risk.

Emerging market corporate debt
We believe EM corporate debt will continue to benefit from an increasingly stable macroeconomic environment and a gradual pickup in growth. In addition, the capex adjustments and cost reductions that we saw throughout 2016 are now translating into improvements in credit fundamentals. In this environment, we believe credit selection will dominate returns.

In addition, emerging market corporate debt has shown low sensitivity to US rates historically, and the asset class also tends to have lower duration. Despite the fact that the US may be on track to increase rates, global developed market yields remain low relative to recent years. In our view, emerging market companies offer attractive yields with less duration risk than many of their developed market peers. Within the emerging market corporate space, we prefer shorter-duration strategies that we believe will offer superior carry and roll-down per unit of duration and volatility risk.

Going forward, there are several macroeconomic factors that we believe will continue to be supportive of emerging market corporate debt, including gross domestic product growth in Asia and Latin America, an improving economic and political atmosphere in Brazil and stabilising foreign exchange and energy prices. Emerging market company fundamentals are also improving and will likely continue to benefit from an increasingly stable macroeconomic environment.

Technicals remain favourable and, over the next year, we do not expect to see sharp reversals in fund flows. Net financing is expected to stay subdued as a result of continued liability management among EM corporates. Also supportive of the asset class, cash flows from amortisations and coupons are expected to remain robust in the coming years.  

Going into 2017, selectivity and active management are critical. In our view, a disciplined, bottom-up approach to credit selection is paramount to seeking the most attractive risk-reward opportunities in the growing emerging market corporate asset class.

Emerging market equities
There are grounds for optimism when it comes to what we view as the most important driver of performance - corporate earnings. Productivity growth is now exceeding real wage growth, a trend that looks set to continue after years of capex investment. Absolute and relative valuations, particularly cyclically adjusted price-to-earnings ratios, appear attractive by historical standards. Emerging markets earnings forecasts are also generally less efficient than developed equities as fewer sell-side analysts are following the companies, leading to potential opportunities for active investors.

Long-term earnings growth is the driver of stock market performance, and the best way of finding unrecognised growth is by identifying quality companies with visibility of earnings over a three-to-five-year time horizon. There are a number of emerging market companies that we believe offer compelling valuations, but only the most adept stock pickers will find those reasonably-priced businesses that can grow their earnings over the long term.

Potential risks
Emerging markets are not without risks. Near the top of this list heading into 2017 is trade, given the heavy reliance of many emerging economies on exports. We will be closely monitoring this in 2017 as trade agreements and alliances such as the Trans-Pacific Partnership may fall victim to the global trend toward nationalism. 

A weaker-than-expected Chinese economy and/or faster-than-expected US Fed rate hikes also pose risks, making country and security selection that much more important. In general, we see risks as being idiosyncratic by country and security rather than systematic. 

Conclusion
Conditions look reasonably supportive for emerging markets heading into 2017 but there are enough risks on the horizon that it may be a volatile ride.