The case for emerging markets revisited

Since the beginning of May, global fixed-income markets have sold off aggressively. The 10-year Treasury yields have increased almost 100 basis points, triggered by concerns that an improving U.S. economy would cause the Fed to gradually raise interest rates. The immediate consequence of this shift in market perception has been a sharp sell-off across global fixed-income markets.

The impact on emerging markets debt has been particularly pronounced as the fixed-income sell-off coincided with growing concern over the growth outlook in emerging markets. While gross domestic product growth in emerging markets is still higher than that in developed markets, many emerging markets have slowed over the past 24 months. In contrast, the outlook for major developed markets, especially the U.S. and Japan, remains more positive. We also see signs that the recession in the eurozone could end this year.

Concerns over growth outlook have been exacerbated by fears about capital flow reversals. The prospect for higher Treasury yields and outflows from fixed-income funds have raised the question of whether emerging markets are overly reliant on easy capital inflows. Foreign ownership of emerging markets' local bond markets has risen significantly in recent years. Meanwhile, current account deficits requiring ongoing financing have appeared or widened in several emerging markets countries. This environment has spooked many investors who are concerned that the investment case for emerging markets debt no longer works.

These fears, in our view, are excessive. Emerging markets fundamentals remain strong, and their economies are likely to benefit from a recovery in developed markets. The adjustment in valuations and technical positions is also creating investment opportunities in emerging markets debt and improving flows, going forward. However, differentiation across countries is becoming increasingly important in this environment.

Despite the slowdown over the past two years, most emerging markets are still growing significantly faster than developed markets, including the U.S. In fact, growth in the U.S., the world's largest importer, is expected to benefit emerging markets economies. Similarly, a better outlook for the eurozone and Japan is expected to benefit emerging markets.

A case in point is Mexico. The U.S. accounts for about three-quarters of Mexican exports. Hence, Mexico is likely to benefit from a pickup in U.S. growth. In addition, Mexico is implementing structural reforms to increase its potential growth rate. The outlook for China remains particularly important because of China's critical role for global commodity demand and recent gains in Chinese economic activity data bode well for emerging markets more broadly.

Overall, we believe external conditions for emerging markets growth to remain reasonably supportive. Monetary easing by central banks in emerging markets has created room for improving domestic demand, and fiscal policy is broadly neutral. On that basis, we expect gradually rising growth rates in latter part of 2013 and into 2014, even though it will not be a rapid rebound.

This leaves investors in emerging markets debt to ponder another critical question. How vulnerable are emerging markets to the end of quantitative easing, rising rates in developed markets, and potential fixed-income portfolio outflows? Long-term investors in emerging markets will recall the financial crisis in the 1990s (Mexico, Asia and Russia), which featured a sharp reversal of capital flows to emerging markets.

However, the environment is different now. Most importantly, emerging markets fundamentals are much stronger. Most debt is denominated in local currency and has a much longer maturity profile. Inflation is low, domestic financial markets are less “dollarized” and emerging markets current accounts are in much better shape. In addition, central banks have high foreign-exchange reserve levels that can be used to finance outflows.

Available fund flow data overstates the magnitude of total outflows from emerging markets debt markets. The standard available fund flow data set covers only dedicated emerging markets open-end mutual funds and exchange-traded funds, and these represent only about 20% of the tradable emerging markets debt market. Moreover, the data have a large retail bias and retail flows tend to be driven by recent performance, as opposed to institutional flows, which tend to be more strategic and invested with a long-term time horizon. We believe much of the other 80% not covered in the fund flow data tend to be more stable and more sensitive to valuations, which have improved substantially.

Going by our analysis, we expect to see signs of stabilizing growth in emerging markets by later this year. This view is driven by expectations of better developed markets growth, which will benefit emerging markets. We also believe the dependence of emerging markets on quantitative-easing-driven portfolio inflows is generally overestimated. Portfolio inflows are not the main source of capital inflows and a substantial share of past portfolio inflows are strategic allocations that are far less volatile than retail flows would suggest. We also find current valuations more attractive relative to other fixed-income asset classes that have not been hit as hard during the recent sell-off. We expect these trends to be gradually reflected in market prices, while being cognizant that differentiation between countries and sectors will be particularly important in this environment.

Steffen Reichold is an emerging markets economist with Stone Harbor Investment Partners, New York.