While a continued improvement in activity increases the risk of monetary policy tightening, overall bond yield levels are likely to be anchored by the benign inflationary backdrop. This strengthens the expectation of investors of a very gradual policy normalisation by the Federal Reserve and other key central banks like the ECB and Bank of Japan.
As the chart shows, the EMD asset class corrected sharply in November last year, when Donald Trump was elected President of the United States. His campaign contained a strong protectionist agenda while he also promised huge fiscal stimulus measures, which after his election caused a substantial appreciation of the US dollar and sharply rising US bond yields.
However, already since the end of 2016 markets have gradually priced out these expectations as it became clear that Trump did not follow up on his protectionist rhetoric while he also faced significant obstacles in Congress with regard to his domestic agenda.
The developments in US politics continue to be unpredictable, so it remains difficult to assess the impact of the current US administration. US trade policies could obviously affect emerging markets, but given the political deadlock in the US this is not our base case.
At the same time, global trade growth started to accelerate at the end of 2016, contributing to emerging market export growth. While EM growth momentum improved thanks to external demand, capital flows to emerging markets increased as US bond yields fell and the dollar weakened.
Combined with the steady downward trend in inflation, this enabled EM central banks to cut interest rates. Financial conditions eased, stimulating domestic demand. Since March, a slow recovery in credit growth is visible in emerging markets ex-China.
China, at the end of last year, was still seen as a key risk factor, but has surprised with decent growth figures in the first half of this year. The PMI indicators of the past few months suggest this benign picture has continued in the third quarter. Chinese credit growth continues to soften but only moderately and hardly affecting the real economy.
In the coming months, volatility might increase on the back of heightened tensions on the Korean peninsula or the Federal Reserve’s gradual policy normalisation. However, neither is likely to disrupt our more structural positive view in the medium term. Most likely a short period of market weakness could provide opportunities to selectively add risk.
At the moment we do not have a strong preference for hard or local currency debt. All categories have seen healthy inflows. This year we are likely to surpass the record level of inflows seen in 2012.
EMD hard currency valuations are close to fair, with spreads in a stable range for the past few months. Based on the improving fundamentals and positive market technicals, we have a constructive outlook for EMD HC.
For EM local markets, we expect investor inflows to continue into the higher yielding basket where real rates have been bolstered by falling inflation.
Real interest rates are close to historic highs and the real interest rate differential versus developed markets has also grown. This bodes well for a continuation of portfolio inflows.
In this environment, EM currencies should continue to regain some of the ground lost over the past five years.
Marcelo Assalin is head of emerging markets debt at NN Investment Partners