This last weekly of 2016 asks why EM fixed income in particular outperformed DM fixed income markets in 2016. In addition to reviewing the underlying economic, political and market developments that brought about this outcome the report also concludes that there is more good news in the pipeline for EM investors in 2017.
The Financial Times ran a story last week about how Chinese scientists have successfully implanted 3D printed blood vessels made from stem cells into rhesus monkeys, marking an important step towards printing blood vessels and other organs for human transplants. It is difficult not to contrast this development with President-elect Donald Trump’s contemplation of tariff increases to protect inefficient old-world steel and apparel industries. Indeed, in many ways this little anecdote sums up 2016, which was a year that marked important turnings points for Emerging Markets (EM) and developed economies alike.
For developed countries 2016 was the year when mainstream politicians were finally ejected from power in favor of populists. This triumph of populism had been in the works ever since the Developed Market Crisis (DMC) of 2008/2009. It is a direct consequence of years of failure on the part of mainstream politicians to address the concerns of voters – stagnation and rising inequality.
How did developed economies end up here? Unwilling or incapable of tackling the true causes of stagnation – debt and declining productivity – mainstream politicians have for years relied solely on short-term stimulus measures ranging from zero interest policies, massive debt-fuelled fiscal spending and Quantitative Easing (QE). Unfortunately, these policies have not worked. Instead, it has become more evident every year, even to voters with next to no interest in matters macroeconomic, that these ‘cures’ were making the disease even worse. In addition to not raising living standards, for example, QE clearly contributed significantly to rising income inequality, thus underlining the universal truth that administering the wrong drugs can destroy rather than heal.
The lurch into populism in developed economies should worry all investors, especially those with large exposures in developed markets. Not only are valuations in these markets excessive after years of QE, but the underlying political conditions are now such that economic health may be jeopardized significantly. Clearly, closing borders, stoking geopolitical tensions, withdrawing from international economic and trade partnerships, persecuting immigrants and other minorities are not good for trend growth rates.
By contrast, EM countries tend to respond to economic downturns much more robustly than developed economies. Firstly, EM countries do not have the luxury of printing money or engaging in reckless borrowing. Secondly, they tend to inhabit a domestic political reality, which affords little tolerance for macroeconomic shenanigans. Huge numbers of people in EM live at or below the poverty line without access to social security, unemployment benefit or inflation hedges and they have no patience with politicians who mess around with the economy. Hence, if politicians in EM countries screw up they often face impeachment or other means of ex-communication very quickly. This is then followed by rapid and often deep reforms to fix the underlying economic problems. It is precisely this feedback loop from economic shocks to better politics to better economics, which keeps EM countries fundamentally healthier and which is missing in developed economies.
2016 was a good year for most EM countries, because EM countries were able once again to move forward after a few years of adjustment to much tighter financial conditions. Investors have pulled money from the EM asset class for several years in order to chase returns in QE-sponsored developed markets. This triggered sharp cyclical slowdowns in EM, although EM economies never grew less than twice as fast as developed economies. However, EM countries undertook prudent macroeconomic management and reforms, which made it possible for them to weather the storms with surprisingly few casualties. By late 2015 the combination of cheaper currencies and declining inflation rates had rendered them competitive and in 2016 the IMF revised EM growth rates higher twice, while growth rates were revised lower in developed economies.
There was also an important change in global currency markets in 2016. After declining by about 10% per year over the previous five years EM currencies were broadly unchanged against the Dollar in 2016. While the Dollar rallied strongly against all currencies in late 2016, including EM FX, EM currencies had racked up strong returns prior to Q4 and outperformed both EUR and JPY in the Dollar rally going into year-end. The fact that EM currencies are ending the year broadly flat against the Dollar is significant. Even local currency bonds, the world’s most despised asset class, have dramatically outperformed developed market bonds of the same duration in Dollar terms in 2016.
Indeed, valuations were extremely compelling – and remain so. In February 2016 the average bond yield across all EM fixed income themes was higher than before the DMC when the Fed had rates at 5.25%! Moreover, in local markets yields were high in real terms too, while Dollar-bond spreads sat well above fair value. As investors in developed markets were piling into the longest duration bonds they could find – a phenomenon we dubbed the ‘last QE’ trade2 – only to suffer horrific losses in H2 2016 EM local bonds steadily clocked up positive high single digit returns in Dollar terms. Dollar sovereign bonds did the same and Dollar corporate bonds had even better returns. There is little prospect of a turn-around in developed market bonds, barring, perhaps, under a recession, but there is still plenty of value in EM fixed income.
Finally, technicals were and remain strong in EM. By 2016, positioning had become so light in EM fixed income that even major risk-off events, such as the Brexit vote, the Turkish coup attempt and Fed hike fears no longer had the power to cause big EM sell-offs. There were, in other words, very few sellers left: retail and crossover investors, hedge funds and banks were largely out of the market and real money investors were – and remain – underweight. In fact, institutional investors continued to pull money from the asset class throughout 2016 albeit at a slowing pace. ETF inflows to EM equity and fixed income briefly spiked to USD 50bn after Brexit, but left immediately after Trump was elected, with little overall long-term consequence for an asset class of USD 18.5trn. The implication of light positioning and quality hands is simple, but powerful: prices respond asymmetrically to global events. The downside risks are smaller, while the upside is larger when investors return to the asset class.
As the start of 2017 approaches the outlook for EM fixed income is brighter than in many years. EM economies are demonstrably healthier, while the deterioration in politics should lead to genuine concern about the economic health in many developed economies. EM assets are already delivering better returns due to deep value, yet still look attractive in price terms compared to the over-bought and technically vulnerable markets in rich countries. Finally, EM positioning is light, so could improve significantly. Inflows typically respond to performance and should help EM growth to improve further.
Jan Dehn is the head of research at Ashmore Group Plc, a specialist emerging markets asset manager with over US$ 50 billion under management.