The financial profiles of emerging markets are far better than they were just five years ago, but when global investors get worried about risk, emerging market assets are among the first things they sell.
True to form, EM currencies, stocks and bonds have been hammered this year as volatility picked up in the markets. The MSCI Emerging Markets Currency Index — a basket of 26 EM currencies — was down 5 percent for the year through Sept. 25. EM stocks are down 10.5 percent, and bonds are down 7.7 percent — the worst performance of any major global fixed-income asset class this year.
"Given the state of the world with strong U.S. growth and contained inflation globally, it's hard to imagine that emerging markets would suffer so much this year," said Pablo Goldberg, a senior fixed-income strategist with BlackRock. "There's been a general pullback from risk in emerging markets."
The spread of average EM bond yields over comparable duration U.S. Treasurys has widened dramatically, and the average yield on the JP Morgan Emerging Markets Bond index — a broad index of EM sovereign bonds — was up to 5 percent as of Sept. 25.
George Rusnak, co-head of fixed-income strategy at Wells Fargo Investment Institute, thinks that presents a buying opportunity. "It's hard to buy when others are selling, but blood is in the water and that's when you want to get involved," said Rusnak. He has changed his view of emerging market bonds from neutral to favorable since the beginning of the year.
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"We look for value," he said. "Domestic high-yield bonds are priced for perfection, so you're not getting paid for a risk that is still there.
"With emerging markets, you get more compensation for the risk," Rusnak added. "If we want to get aggressive, it's in emerging market debt."
Some of his more aggressive ideas include the sovereign bonds of Brazil and Mexico in Latin America, and India and Indonesia in Asia. They carry significant risks. The Indonesian 10-year sovereign bond yields 8.24 percent. Brazilian 10-year bonds pay 11.6 percent. "We feel we're fairly compensated for the risk."
Jim Caron, fund manager at Morgan Stanley Investment Management, also sees the recent weakness in emerging markets as an opportunity. "We're still in a global growth environment, and the trajectory for emerging markets is still positive," said Caron. "Valuations tell me that emerging market assets are attractive.
"They have good fundamental attributes but have been subject to political risks that I hope are temporary," he added.
The turmoil in markets such as Turkey and Argentina hasn't helped. The Argentine peso has dropped by more than 50 percent this year, and the Turkish lira by nearly 40 percent. Spreads on both countries' debt have widened dramatically. Other country-specific risks in emerging markets include the Brazilian elections, trade issues for Mexico, and recession and land reform issues in South Africa. In emerging markets, bad news tends to spread.
"The contagion in emerging markets happens through different channels and it tends to be greater in periods of monetary tightening in developed markets," said BlackRock's Goldberg. "Liquidity is an issue. Investors will sell what they can sell."
The concern about global trade is also weighing on export-driven emerging markets. President Trump's unconventional trade policies — or lack thereof — have yet to seriously hit global trade and economic growth, but it still has investors on edge.
"We use to abide by one set of trade rules in the past, but now we're moving towards bilateral agreements," Caron said. "The rules are no longer uniform."
While many of President Donald Trump's threats have been directed toward developed markets such as the European Union and Canada, he has also targeted Mexico, China and other EMs for "unfair" trading practices.
If the tariff battle with China becomes a full-blown trade war — a possibility now that the United States has imposed tariffs on an additional $200 billion in Chinese exports, and China has replied with $60 billion of its own — it will hurt growth in the emerging markets as a whole.
The biggest headwind for emerging market bonds as a group, however, is the rise in U.S. interest rates and the strength of the U.S. dollar. Both make EM bonds relatively less attractive. The question is how much further U.S. rates will rise and how much higher the U.S. dollar can go.