Viewpoints

Emerging Markets Asset Allocation: Opportunities in a Time of Uncertainty

While there is substantial uncertainty ahead, we believe the pickup in growth and supportive liquidity conditions favor emerging markets investments.

Emerging markets have begun a process of healing in recent months, kick-started by aggressive healthcare and economic policy actions globally. We expect a bumpy recovery, with shocks from the coronavirus pandemic likely to have long-lasting, albeit varied, effects on the outlook for markets and economies. Yet we remain confident that massive monetary and fiscal stimulus will continue to limit market volatility, which is near 20-year lows, and support emerging markets (EM) investments.

This line graph depicts five indexes, representing emerging markets equities in local currency, external debt, corporates, and currencies, from June 2018 to 14 August 2020. The prices of these assets peaked in the first quarter 2020, before plunging as the novel coronavirus began to spread. Asset classes proxies are as follows: MSCI Emerging Local Index, J.P. Morgan EMBI Global Diversified Composite, J.P. Morgan Corporate EMBI Composite Index, J.P. Morgan GBI-EM Global Diversified Composite Unhedged USD, and J.P. Morgan ELMI+ Index, respectively.

Turn in the cycle

At PIMCO, we use a top-down framework to assess how global conditions will impact EM investments, focusing on changes in three primary drivers – the business, liquidity and political cycles. With policymakers firmly erring on the side of doing more, we think major central banks will continue to support the liquidity and business cycles for a long time. In our view, however, the effect of this policy support in some countries will likely be tempered by accelerating populist policy trends, making country-specific risks more important. The upcoming U.S. election and its potential impact on relations with China and other countries will take center stage.

The improving business cycle is positive for emerging markets. EM returns typically are strongest when the global manufacturing PMI — a good proxy for economic activity — is below its long-term average of 51.4 and rising, as it is now (see Figure 2). A steady grind higher and a broadening rebound are more relevant than the exact shape the recovery will take, given the strong liquidity support. Near-term drags associated with the pandemic are to be expected, but we believe these will be more localized going forward. With global monetary and fiscal policy likely to remain supportive for a long time, we believe the manufacturing index can return to its mean, lifting EM returns in coming quarters.

This chart illustrates average monthly emerging market asset class returns throughout the phases of the economic cycle for the last 10 years. The Purchasing Managers Index (PMI) is used as a proxy for economic activity. When the PMI is above average and rising, returns are robust, with emerging market equities performing best, rising 1.5%, and currencies performing worst of the group, edging up 0.6%. As PMI plateaus, returns are positive but less robust, with emerging market equities continuing to perform best, rising 0.7%, and currencies bringing up the rear, rising 0.3%. When the PMI is below-average and falling, emerging markets are at their worst. Average monthly returns ranged from a high 0.4% for government bonds to a low of negative 0.6% for currencies. Finally, when PMI is below average but rising—where we are right now—emerging markets perform best. On average, in this segment of the cycle, their monthly return over the last 10 years ranges from a gain of 2.1% for equities to a gain of 0.8% for currencies. Asset classes proxies are as follows: MSCI Emerging Local Index, J.P. Morgan EMBI Global Diversified Composite, J.P. Morgan Corporate EMBI Composite Index, J.P. Morgan GBI-EM Global Diversified Composite Unhedged USD, and J.P. Morgan ELMI+ Index, respectively.

The EM assets we favor

At PIMCO, anticipating potential changes in macro factors is central to our investment process. Our asset allocation decisions in multi-asset emerging markets portfolios have typically revolved around contrasting “balance sheet” assets that are largely driven by sovereign debt levels, and “income statement” assets that are more sensitive to nominal growth (see Figure 3). As the economy emerges from a deep recession, we typically shift toward more growth-sensitive assets. But we think uncertainties around how the coronavirus progresses will make this cycle different.

Shrinking revenue during the pandemic shutdown and countercyclical fiscal policies have resulted in a marked rise in debt on sovereign balance sheets globally. We expect the recovery to be uneven from country to country, further widening the already pronounced divide in quality between investment grade (IG) and below-IG credits. This quality gulf makes rigorous macro analysis more important in identifying higher-quality credits.

Accordingly, we continue to prefer more defensive EM balance sheet assets, specifically external credit and local duration with greater exposure to the Fed’s monetary easing and credit support programs in developed economies.

Despite higher sovereign debt levels, sustainability remains backstopped because of lower domestic funding costs and recourse to weaker exchange rates.

We remain cautious on cyclical EM risk that is more dependent on nominal growth. We are neutral on EM currencies. Although valuations have become more attractive against the U.S. dollar, we believe that the global recovery will need to broaden and deepen for higher beta EM currencies to overcome current challenges of historically low carry and high volatility. Equities, we continue to view as less attractive, believing that the aggressive recovery in earnings is priced in to current valuations, capping the upside but not the volatility of this asset. (See Figures 3 and 4 below.)

This chart shows PIMCO views of the valuations of the four categories of emerging markets assets:  local duration, external credit, currencies, and equities. PIMCO believes the less growth-sensitive balance sheet assets, namely local duration and external credit, are more richly valued. PIMCO also believes equities, a more growth-sensitive income statement asset, have richer valuations. Finally, PIMCO believes currencies, another growth-sensitive income statement asset class, has cheaper valuations.

This illustration shows PIMCO’s weighting for each of the four emerging market asset classes. For PIMCO is slightly overweight local duration; moderately overweight external credit; neutral on currencies; and moderately underweight equities.

Local duration

We believe EM local duration (sovereign debt denominated in local currency) continues to offer the best potential risk-adjusted returns, given the uncertainty that surrounds the economic outlook. Despite recent monetary easing, we think economic slack will anchor inflation at historically low levels, allowing central banks to continue their highly accommodative monetary policies. We think EM local duration positions will continue to serve as good diversifiers to global rates mandates, given relatively high real yields. Specifically, we are focusing on countries where yield curves are steep — reflecting large financing needs or expectations of swift policy normalization, or both — and high real yields can be harvested without taking currency risk. Mexico, Russia, and China fall into this category.

This chart shows the average 10-year real-yields of emerging market sovereign bonds relative to real 10-year yields in domestic markets. It runs from the beginning of July 2015 through July 2020. Real yields are calculated by subtracting the expected inflation rate. During this period, the differential between emerging market real yields and domestic market real yields more than doubled from slightly over 2% in July 2015 to more than 4% later that year, before briefly dropping back to less than 3% in 2016. From there, the yield differential steadily climbed and traded in a range of 3.5% to 4%, with a brief spike above 4.5% in mid-2018 and a spike above 5% in March and April 2020.

EM external

Sovereigns: EM sovereign credit remains a natural destination for crossover investors, given ultra-low rates and rich credit valuations in developed markets. We expect prudent policymaking from established investment grade names, but see more risk of error for lower-quality credits. Valuations in the investment grade segment of the benchmark have recovered but still look reasonable. Favorable resolution to idiosyncratic factors driving some high-yield index constituents could provide additional upside. We remain focused on credit selection and diversified portfolios, emphasizing:

  • A preference for higher-quality and more liquid names
  • Selective participation in new issues in stronger credits
  • BB rated credits that entered the COVID-19 crisis with good fundamentals
  • Countries with strong multilateral support
  • Limited exposure to oil-dependent economies

Corporates: EM companies entered 2020 with lower leverage and limited refinancing risks. Following the initial shock, we expect their solid fundamentals to reassert themselves, supported by lower capex spending and financial discipline. Declining local interest rates provide EM corporates additional opportunities to replace hard currency debt with local currency debt, improving the supply-demand technical position for some CEMBI issuers even more. Valuations remain attractive, with J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) lagging the move in U.S. corporates, while we anticipate the default rate in EM to remain low. Sectors we favor include Central and Eastern Europe and the Middle East (CEEMA), Asian TMT, LatAm financials, and EM REITS. We believe LatAm is the most vulnerable region — facing weaker recovery outlooks and sovereign downgrade risks — though we see value in the financial sector.

EM FX 

Gradual and uneven EM growth prospects, coupled with lower carry, mean more uncertainty for EM currencies. Valuations are cheap, having only improved marginally since the onset of the pandemic, as fair value estimates have declined along with weaker terms of trade and wider sovereign spreads. And a continued global recovery and supportive liquidity environment should lead to improving capital flows to EM.

Nonetheless, growth impairment stemming from the COVID shock implies a persistent need for loose EM monetary policies, persistent monetary financing of fiscal deficits, and relatively weak exchange rates. These cross currents accordingly leave us neutral on EM FX, despite growing expectations of a broad dollar depreciation cycle. Catalysts to move overweight would be a broadening global recovery cycle in which the U.S. participates but does not lead; or a much stronger Chinese property cycle.

EM Equities

Equities are expensive globally, and EM is no exception. Within the EM complex, our concerns about weak nominal GDP growth are compounded by problematic sector composition, given the larger weights of fossil fuels and banks in the index. Trading at a forward P/E of roughly 15x, aggregate valuations are several standard deviations above recent averages, capping upside. At current prices, the U.S. dollar earnings per share (EPS) of the MSCI Emerging Markets Index required to bring the forward P/E back to its five-year average of 11.9x is about $89. This implies 25% growth over the $71 achieved in 2019. This seems hard to materialize. Compounded EPS growth from 2013-2019 was close to zero for MSCI EM. And reduced operating leverage in a low nominal growth environment is likely to keep EM return on equity unattractive compared with developed markets. We view Asia as an anomaly. Asia is leading the cycle on positive earnings revisions and has a higher share of new economy sectors in the region.

Final thought

While PIMCO anticipates a bumpy recovery ahead, upswings in the global business cycle – helped this time again by massive policy stimulus – are supportive of returns for emerging market assets. We anticipate growth and investment returns will vary on a country by country basis, highlighting the importance of our rigorous investment process. Given lingering uncertainties, we continue to prefer higher-quality local duration and external debt. We are cautious on more growth-sensitive assets, namely currencies and equities.

The Author

Pramol Dhawan

Head of Emerging Markets Portfolio Management

Vinicius Silva

Portfolio Manager, Emerging Markets

Gene Frieda

Global Strategist

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Disclosures

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