Headwinds remain for emerging markets, but bright spots on the horizon

Among the gloom and doom of four years of emerging markets relative underperformance vs. the developed world, money management executives have found several bright spots.

While the headwinds that have been battering emerging markets do not look likely to disappear in 2016, cheap valuations are beginning to attract the attention of money management executives and their clients.

The slowdown in emerging markets growth, continued strong dollar rally, and the ongoing reversal in the commodities super cycle — particularly in the materials sector — will continue to put pressure on emerging markets.

These issues date to 2011, and are “bad for the outlook as none look like they are poised to clear in the near terms,” said George Iwanicki, global co-head for emerging markets asset allocation at J.P. Morgan Asset Management, based in New York. The slowdown in emerging markets growth has resulted in the “effective disappearance of earnings growth in emerging markets,” with the growth premium vs. developed markets at the low end of the historic range.

“It is hard to see why 2016 should be the year of a sharp rebound. It is hard to make the case for any reversal in 2016, but the hope is that some will begin to alleviate or finish running their course,” said Mr. Iwanicki.

The good news, however, is that valuations still look relatively cheap for underlying equities, he said.

While the time is not right to be reallocating to the asset class, Mr. Iwanicki said he is encouraging clients to start setting parameters around when they might make the move. “We are at valuation levels where I personally continue to encourage longer-term investors not to allocate back to the asset class today, but rather we are at valuation levels where we have to be thinking about what is the level at which I buy? What are the catalysts to get more buying, or what are the valuation levels that I would consider adding more (exposure) even without a catalyst?”

At the top of the list is India, which has been the darling of emerging markets for the past two years under a government run by Prime Minister Narendra Modi, elected in 2014, and Raghuram Rajan, the new central bank governor who came into the role in 2013.

The rising middle class and services sector in China also was highlighted as a potential bright spot next year.

But it is India’s fixed-income market that has whetted the appetites of investors, in the form of so-called masala bonds, of which the first corporate issue could be done in January. These bonds are rupee-denominated offshore bonds, issued by Indian companies, and targeting the international market. In September, rules around these bonds were relaxed, opening the market.

“The (Indian rupee) market is very big and deep, with a number of institutional investors onshore with huge amounts of assets to allocate into the government and corporate bond markets,” said Brent David, portfolio manager in the emerging markets debt team at BlueBay Asset Management LLP in London. “It has historically been difficult for international investors to get involved.” But recently the Reserve Bank of India has increased limits of foreign investor holdings, and has been working on regulations that would allow Indian companies to issue bonds offshore in the local currency.

“They are not the first economy to do that, but this is a new and positive development,” said Mr. David. He said there has been a focus on how currencies on global corporations’ balance sheets mean assets and liabilities might be mismatched. “From an investor perspective looking at the balance sheet of a number of these corporates, they would rather they were issuing in their own currency.”

Two months ago, the Reserve Bank of India issued final approvals and signed off on the masala bonds format. It has taken time, with issues such as withholding tax payment — paid by the issuers; capital appreciation, and capital gains tax, all needing work.

And interest is coming in. Over the past three weeks to a month, Mr. David said BlueBay has had calls and talks with a number of Indian corporations, particularly with the “quasi-sovereigns.” What is needed is a number of issues to create a quasi-sovereign curve, against which other corporations can issue bonds, he said.

“This is pertinent right now, given the negative time we have seen in emerging markets, but India has been one of the standout stories. We think a number of institutional investors would be open to investing in these types of markets,” said Mr. David.

He predicts interest particularly given the breadth of the market and opportunity: the local currency corporate bond market is $5 trillion in volume, and the local currency sovereign bond market $6 trillion, he said. That compares with the dollar-denominated corporate bond and dollar-denominated sovereign bond markets, at between $1 trillion and $1.5 trillion each.

Also singling out India was Anand Shah, chief investment officer, India, at BNP Paribas Investment Partners, who highlighted the country’s demographics and forecast growth as positives. “That also means there is a huge supply of labor force, which is quite cheap. The process of getting the last section of India out of poverty has already begun,” said Mr. Shah at a briefing in November.

The country also is expected to become the fourth-largest economy in the world by 2020, behind China, the U.S. and Japan, up from 10th place in 2013. By 2040 it will be the second-largest, behind only China, said Mr. Shah.

“For the outlook for India’s equity markets, most stars have aligned. Things changed in 2013 with the new central bank governor, (and while) the change in government is yet to deliver, it has taken a few steps in the right direction. And the lower oil price has helped,” said Mr. Shah.

China also is benefiting from a demographic play, and its industrialization. Chi Lo, senior economist, Greater China, at BNP Paribas Investment Partners in Hong Kong, said at the same briefing that the tertiary sector of China — the new part of the economy including financial services, entertainment and health care — is now bigger than the secondary sector of manufacturing. “The growth in the new economy is not strong enough to offset the contraction in the old economy. But it is not all bad news; the world wants to see China rebalance,” he said. He highlighted railway passenger growth of around 15% year-on-year over the past few years, “reflective of the new economy,” and “huge” growth in online banking and Internet sales.