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.
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.
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.)
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.
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.
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.
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.
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.