Author: NN Investment Partners
The recovery in credit growth in most emerging markets is a good sign that EM growth will maintain its momentum and that the regions’ equities will continue to outperform.
Despite rising yields in the developed world, financial conditions in emerging markets have not tightened yet. EM equities continue to benefit from good domestic demand growth prospects and positive earnings data. Credit growth, in particular outside of China, has shown a clear recovery for the first time in more than six years. This recovery is a good sign that EM growth will maintain its momentum and that the regions’ equites will continue to outperform. In our overall tactical asset allocation, we reduced our underweight in treasury bonds, mainly in response to improving institutional flows and low positioning. Within fixed income, our preference is for higher-beta spread categories, particularly global high yield.
Investor sentiment for EM assets has recovered
The sharp correction in tech stocks and rising Fed expectations in late 2017 took their toll on emerging market (EM) equities. Nonetheless, prospects for EM domestic demand growth remained positive, mainly because of the steady recovery in credit growth in the region.
The IT correction did not persist and the continuous rise in Fed fund futures has so far not had a negative impact on portfolio investment flows to EM. Meanwhile, macro and earnings data across the EM universe remain good. The improved prospects for domestic demand growth in most EM countries is probably the main reason investor sentiment towards EM assets has recovered again since the mini-correction between mid-November and mid-December.
Tech stock price momentum no longer negative
Following a strong 2017 performance, the IT sector is still vulnerable, and its 27% weight in global emerging markets remains a reason for caution. But with price momentum in IT stocks no longer negative, investors can probably afford to focus less on the tech-related risks for the EM equity asset class as a whole.
Sector leadership in EM has been taken over by financials, which on the one hand is understandable, given the steady recovery in EM credit growth outside of China, but on the other hand is remarkable in view of the continuous rise in Fed fund futures and developed market (DM) bond yields.
Investors still like EM debt
This development is creating an environment that highlights the vulnerability of EM capital flows. But as long as investors continue to believe in a gradual normalisation of US and European monetary policy, they seem happy to allocate money to the high-yielding EM fixed income markets, particularly in local-currency EM debt markets, where the yield differential with US Treasuries remains a hefty 3.5 percentage points.
The widely held view is that the Fed will not hike by more than 75 basis points in 2018. This is almost priced now. Still, the upward trend in Fed fund futures has been strong in the past year and a half, especially since September. If it continues, EM assets are likely to be impacted at some point.
Noteworthy recovery in credit growth
Just as important as the global liquidity environment, perhaps, is the fundamental strength and economic growth momentum in EM. Flows to EM have remained strong, despite rising DM interest rates, because macro imbalances have dissipated and growth momentum has remained positive since mid-2016.
In recent quarters, moreover, there has been a clear recovery in credit growth, the first in more than six years. This is a key new positive that in the past always coincided with strong EM equity outperformance. It is the main reason we remain confident that EM growth will keep its positive momentum and that EM equities will continue the outperformance trend that started two years ago.
Demand growth in China likely to slow
The outlook for EM is favourable despite China’s transformation to an economy that is less credit-driven and growing at a structurally slower pace. Chinese domestic demand growth will probably slow somewhat in the coming months and quarters. The authorities continue their de-levering campaign and the weakness in property investment should become more visible in the overall growth data.
At the same time, the strength in export growth and the tighter control of capital flows by the authorities are the main reasons that the Chinese growth moderation will probably be moderate in the coming year, amounting to only about half a percentage point.
Current environment looks favourable for EM equities
Credit growth in China was again weaker in December, mainly because of lower mortgage and household lending growth. Broad credit growth, which includes the shadow banking activities, now stands at 11.8%, down from 12.2% a month earlier and 18% a year earlier. That compares with nominal GDP growth of between 10% and 11%, which means that leverage growth has already become modest.
Outside of China, there is room in EM for credit growth to drive domestic demand growth. The macro adjustments of recent years in the form of smaller external deficits and cheaper currencies, as well as growth-enhancing structural reforms in countries such as India and Argentina, should help move fixed-investment and consumption growth in EM higher in the coming years.
This is typically a good environment for EM equities, not only relative to DM, but also relative to EM bonds, which are less growth-sensitive and more dependent on changes in expectations about global liquidity.
Reduced underweight position in Bunds
While the risk/return equation is still not favourable for an investment in German Bunds and the global macro outlook continues to hint at a further rise in yields, we upgraded Bunds from a medium to a small underweight. This was mainly a technical adjustment in response to improving institutional flows and low positioning, after yields rose to the upper bound of the 2017 trading range.
We are currently neutral on spread products with a preference for higher-beta spread categories, particularly global high yield. We closed the overweights in USD and EUR investment grade, where total return forecasts are least attractive.
We moved USD high yield to overweight due to less-stretched valuations, potential positive spill-over from US tax reform, a solid macro outlook and supportive commodity prices. We closed the underweight in emerging market hard currency sovereign debt in response to renewed inflows. Commodity prices, sentiment and USD weakness are also supportive.