How multi asset can take advantage of emerging market tailwinds

As the global growth rates firms up, many emerging market economies are powering ahead of the developed world. In aggregate emerging economies are expected to grow by 4.1 per cent in 2017, with developed markets growing by just over 2 per cent. These superior growth dynamics aren’t the only tailwinds supporting EM assets. 

Traditional concerns about the higher risks of investing in more potentially volatile EM economies and companies have been receding as investors have seen signs of positive structural change in the developing world. Many EM countries have been implementing big political and economic reforms focused on macroeconomic stabilisation. This has helped bring domestic inflation under control and shored up their currencies. 

This, in turn, has opened the door for many EM governments to move towards more stimulative policies, which should be positive for EM bonds and equities alike. 

As inflation has become more benign, producer pricing power has improved, benefiting EM companies’ margins and driving earnings growth as well as improved credit metrics. And with the external balances of many EM countries having improved significantly, EM economies are now less reliant on foreign capital and less vulnerable to rising interest rates in developed markets—things that have hurt emerging economies badly in the past.

So how are these changes impacting on EM assets?

China’s economy is continuing to make the big structural shift away from export-led growth, towards a more balanced model with greater reliance on domestic demand and investment—a supportive trend for many of the country’s fast growing more domestically-oriented businesses.

Local motorway operator Jiangsu Expressway is a good case in point. Its business is poised to benefit from increasing investment in the domestic infrastructure—and from higher traffic volumes as stronger consumer spending power boosts car and truck ownership. In addition, new safety regulations to prevent truck overloading should prove positive for Jiangsu since they should result in loads being spread over more trucks—thereby increasing the number of trucks paying tolls to use its network. We think the company’s shares could enjoy good upside potential on the back of its very strong returns during the first quarter of this year.

In some other EM countries, the secular changes under way make a stronger case for investing in their fixed-income markets.

Mexico, for example, is experiencing something of an economic slowdown, which doesn’t augur well for its relatively pricy equity market. But this slowdown is curbing inflationary pressures—a positive for Mexican sovereign debt, which already benefits from the government’s firm bias towards more prudent economic policies. Peso-denominated government bonds are rated investment grade, but the 10-year debt is yielding more than 7 per cent, thereby offer a highly attractive combination of strong return potential but limited risk exposure.

Other EM countries offer clear value on the currency front.

Argentina’s troubled history as a borrower means that its government bonds still fall firmly within high-yield territory. But President Mauricio Macri and his market-friendly administration have managed to negotiate an agreement with the country’s international creditors and it’s set to regain access to foreign capital. These positive developments make local peso sovereign bonds look doubly attractive: not only do they offer an attractive yield of 14 per cent (as at the end of April), but the currency exposure provides one of the highest rates of carry in developing markets (18 per cent as at the start of May).

Notwithstanding the tailwinds generated by high rates of domestic growth and positive reform momentum, many emerging assets still benefit from attractive valuations relative to their developed market counterparts.

EM equities are trading at a significant discount to their developed peers, while local currency-denominated EM debt offers a particularly strong yield uptick versus developed market bonds. And while capital flows have rebounded back into EM assets recently after years of heavy outflows, most investors remain underweight. This seems to suggest that there’s ample room for additional allocations in future, which could underpin emerging asset prices even further.

Morgan Harting is portfolio manager of the AB Emerging Markets Multi Asset portfolio