Emerging markets, despite strengths, still get no respect

  • Emerging market stocks as a group are down more than 10.5 percent, while EM bonds are down more than 7.7 percent — the worst performance of any major global fixed-income asset class this year.
  • The biggest headwind for EM 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.
  • Some in the industry see a buying opportunity.

Emerging markets get no respect.

It doesn't matter that governments in emerging markets are, on average, about half as indebted as those in developed markets. Nor that their economies are growing twice as fast.

Forget that their central banks have generally adopted more investor-friendly monetary policies that are keeping inflation in relative check — Turkey and Argentina being notable exceptions.

Workers at the Brazilian meatpacker JBS SA in the city of Lapa, Parana state, Brazil, March 21, 2017.
Ueslei Marcelino | Reuters
Workers at the Brazilian meatpacker JBS SA in the city of Lapa, Parana state, Brazil, March 21, 2017.

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.

"Emerging markets are not all Turkey and Argentina, and we think the market will figure it out as time goes on." -George Rusnak, co-head of fixed-income strategy at Wells Fargo Investment Institute

Most fixed-income analysts don't see the 10-year U.S. Treasury yield rising beyond 3.25 percent, and expect the Fed to slow its rate hikes next year. If recent trends continue, however, the run on EM assets and currencies could become a rout and a growing burden for countries that have a high proportion of their external debt denominated in U.S. dollars.

"There's a feedback loop in emerging markets between asset prices and fundamentals, but nothing so bad as to justify this broad sell-off," Goldberg said. "Assets may have to get so cheap that investors come back in and we're not there yet."

For both individual and institutional investors, the market for EM bonds has become large and diverse, with assets in ETFs and mutual funds up by a factor of five to roughly $85 billion since the financial crisis. It encompasses both government and corporate bonds denominated in local and "hard" currencies (typically U.S. dollars or euros). JPMorgan, the market leader in EM bond indexing, reportedly plans to expand its index lineup to include blends of these different types of bonds. Fund managers believe it could further expand liquidity and interest in the market.

However, unless and until investors start evaluating emerging markets separately from the broader asset class, EM stocks and bonds will continue to suffer from factors beyond their control. "These markets should trade differently, but we're creatures of habit," said Rusnak. "In a risk off environment, they all get walloped.

"Emerging markets are not all Turkey and Argentina, and we think the market will figure it out as time goes on."

Caron, too, thinks the strength of long-term fundamentals in emerging markets will eventually win the day and that some of the highest real rates in the bond universe will attract investors back to EM bonds. It could be rough getting there, however.

"We're positive on emerging markets, but the reality is, you'll likely be subject to violent swings," Caron said.

— By Andrew Osterland, special to CNBC.com