Lazard’s Donald: Emerging market ‘easy returns’ could soon end

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Consensus on emerging markets over the past year has swung from rejection to seeing them as a source for yield and returns. The easy returns are likely over, and going forward investors in this asset class will have to earn their keep.

In emerging markets, the equity and debt rally continued in the third quarter as the search for yield persisted and on the perception that fundamentals may be improving. The US Federal Reserve’s decision to hold off rate hikes through much of 2016 relieved some of the pressure on commodities prices and emerging market currencies, which has been a significant component of this year’s returns . While the case for a rate increase has grown stronger, we believe that emerging markets should be able to withstand gradual and measured interest rate increases by the Fed.

We recently crossed the 15th consecutive week of inflows for EM equity funds, with cumulative inflows of $24bn. However, flows can turn quickly and unexpectedly, and going forward, the easy returns are likely over. Sustained outperformance will require fundamental improvements, an earnings recovery, and structural, credible reforms.

Emerging markets continue to face a number of macroeconomic challenges and political risks that investors must discount for and security selection will be critical. With the impeachment of President Rousseff finalized, Brazil can turn its attention on fiscal adjustments and reform of its pension system. While we are encouraged by the first steps taken by President Temer, the journey for Brazil will be lengthy with the chance for volatility should Temer’s team be linked to the ongoing corruption investigation. With the unsuccessful coup in Turkey, President Erdogan has consolidated his power and appears to be using the failed putsch as justification for repressive measures against the Gulen movement. In South Africa, President Zuma has been accused of using taxpayer funds on his private home and for allowing insiders to benefit financially from government connections. At the same time, the ANC party appears to be divided, as Zuma openly battles with Finance Minister Gordhan, who faces fraud charges.

However, the reform agenda continues to gain ground in certain countries. In India, President Modi appears to be making progress in his efforts to improve the ease of doing business in the country. A recently approved and comprehensive Goods and Services Tax (GST) is expected to replace the complex, multi-layered taxation system. GST should reduce the amount of red tape, simplify the movement of goods between states, and may even boost manufacturing and exports. In Indonesia, President Jokowi has reshuffled his cabinet for a second time since coming to office to promote a pro-business climate and accelerate infrastructure development. In an effort to finance these large-scale projects, Jokowi has trimmed the country’s fuel subsidies and has implemented a tax amnesty repatriation program.

After several years of emerging markets underperformance, we believe investors today need evidence of solid global growth, a floor for commodities prices, a credible reform agenda and appropriate, measured tightening of monetary policy by the Fed. If these conditions do occur, we believe the potential upside for emerging markets is significant.

James Donald is head of emerging markets at Lazard Asset Management.