Don’t be seduced by emerging market bulls or bears

As emerging market assets are pulled in opposite directions, there are two tempting, but equally mistaken, approaches investors can take.

The first is to sharply increase or cut exposure to EM bonds, stocks and currencies because a compelling case can be made to do so. The second is to be paralysed into doing nothing precisely because you cannot make your mind up between the competing sets of arguments.

Instead, the answer is to be selective. There are several ways to do this, including shifting holdings from local-currency debt towards bonds sold in foreign currencies, and favouring high quality sovereign (and some corporate) investments anchored by strong balance sheets.

The case for an overall increase in exposure to EM draws support from improving conditions within certain countries, the wider global backdrop as well as structural changes within the asset class itself.

Most large and influential countries, including Argentina, Brazil and Turkey, have overcome the financial disruptions they faced in 2018. The shocks were severe, but aggressive policy responses, adequate sovereign balance sheets and, in the case of Argentina, exceptional IMF engagement, allowed the countries to navigate a very challenging year. The price each paid was a meaningful economic contraction.

The rebound in commodity prices has been one tailwind for EM assets thrown up by the wider external backdrop. After falling by 15 per cent in 2018, commodity prices bounced 13 per cent in the first two months of this year, delivering higher export revenues for some EM nations. At the same time, countries’ capital accounts have benefited as falling government yields in more developed economies drive money into higher-yielding EM assets.

The dramatic policy pivot by the Federal Reserve in January has also helped, by providing scope for other central banks to tilt away from more hawkish measures. It is, therefore, not surprising the EM stocks gained 9 per cent in the first two months of 2019, bonds sold in foreign currencies chalked up a 5 per cent return and bonds sold in local currencies delivered almost 4 per cent.

Finally, a notable structural feature of EM investing also provides additional comfort. Despite a testing run for much of 2018, the money invested with EM funds has proved relatively sticky. The outflows, for example, were smaller than history would have suggested given the magnitude of the declines in some EM securities. This supports the view that the asset class is succeeding in developing a deeper and wider base of dedicated investors.

Yet set against this seemingly comprehensive case for a broad increase in EM ownership is an equally-compelling set of bearish arguments that rely on developments in specific countries and the global economic picture.

Starting with countries, it is clear that the transition to faster, more inclusive growth remains elusive for too many of them. This undermines the long-term case for emerging markets while also sharpening the risk of political, regulatory or financial disturbances.

The global economic backdrop is also worrisome. Although committed to reversing a slowdown in China, the traditional measures policymakers have so far deployed — directed lending, reserve requirements cuts for banks and higher investment by state-owned enterprises — are packing less of a punch than in the past. In Europe the lack of significant pro-growth policies, which reflects both country specific as well eurozone-wide political uncertainties, is sapping economic momentum. It could well cut the region’s economic expansion by half compared with last year and, ultimately, expose it to the additional dangers of “stall speed” growth.

Finally, the reason for caution on the asset class is that EM is regarded by many — and for good reasons — as having become a “crowded trade”. This raises the threat that drops in valuations are amplified during bouts of unsettling illiquidity, as many investors rush for the exit at the same time.

Faced with the current bull and bear cases for EM assets, investors could all too easily be trapped into inaction much like Buridan/Spinoza’s donkey, which starves because it is unable to make a rational choice between two bales of hay that are similar in quantity but differ greatly in shape. Or if fund managers avoid that pitfall, the danger is they force large bets that lack sufficient foundation.

The best approach to EM assets is to be selective, including taking advantage of higher yields on shorter-dated bonds and loans in some of the weaker non-investment grade names that, nevertheless, have the reserves to repay debt coming due soon.

With EM assets currently torn between robust bull and bear cases, the right approach for investors is to look hard for those opportunities that exist in between.

Mohamed El-Erian is chief economic adviser at Allianz.