Emerging markets, stealth leader

It’s not always who yells loudest that should be heard. In the US, market participants have been focused on politics of late: the goings-on in Washington, DC, the fate of health care legislation, potential timing of tax reform. In Europe, the recent Dutch election and anxiety over the vote in France have been front and centre, gauges of the influence of populist forces. Obscured by this commotion, however, is that emerging markets have been quietly outpacing all other major market segments for the year to date. EM equities (as represented by the MSCI Emerging Markets Index) are up 9 per cent in local currencies and 13 per cent in US dollars, while EM debt (as represented by the JP Morgan GBI — EM Global Diversified Composite Unhedged USD Index) has risen about 7 per cent (local currency).

Our view on EM has been somewhat mixed. Back in November, our Asset Allocation Committee lowered its 12-month return outlook for both EM equity and debt, with post-election concerns over a shift in US monetary policy, dollar strength and the possibility of increased tension on trade, given Trump campaign rhetoric. At the same time, we acknowledged the strong long-term case for emerging markets, built on improved debt positions, more stable financial systems and growth potential.

Economic prospects prevail, for now

The global rally in risk assets since the US elections has reflected optimism about expansive fiscal policies from the United States. Accelerating global growth has been particularly important in the emerging world. EM economies are expected to grow at their fastest pace in almost three years, driven by Brazil, Russia and China. Although oil prices have recently seen a pullback, commodity prices have generally remained stable, supporting the EM economies that rely on them for expansion.

Moreover, a couple of anticipated headwinds have been a bit less forceful than advertised. Typically when US rates rise, it puts pressure on emerging markets. While the Federal Reserve is on track in raising rates, their current “Fed dots,” anticipating only two remaining increases this year, have been viewed as a dovish sign. Also, the tone of the new administration has softened to some degree on trade. However, we need to watch the politics carefully. Policies like the border adjustment tax or actual restrictions on trade would likely have a negative impact on EM currencies and growth.

Keep an eye on valuations

From a market perspective, there is some vulnerability to a pullback here, given recent advances. Emerging market valuations, like most risk assets, have moved higher. Despite overall price/earnings multiples that remain below those of developed markets, the growth sectors of the EM world are stretched. For the MSCI EM Index, keep in mind that lower-valued sectors like financials and basic materials tend to dominate this benchmark. On the fixed income side, EM bond yields range from 5-7 per cent, depending on the sector, which is appealing compared to 2.4 per cent for the 10-year US Treasury or 0.4 per cent on the 10-year German Bund.

Of course, it’s important not to overgeneralise. Emerging markets are not homogeneous. For example, export-oriented economies in Asia tend to be more exposed to global trade (for better or worse), while some other economies may be driven more by commodity prices or growing domestic demand. Perhaps the important idea here is that the most attention-getting developments are not always the most important ones. Fundamentals are fundamentals.

Joseph V. Amato, President and Chief Investment Officer — Equities at Neuberger Berman