The coronavirus crisis sparked a record flight out of emerging market assets, with more than $90bn leaving bonds and stocks in March alone, according to the Institute of International Finance. But now the asset class is making a comeback.
This month’s breakthroughs in the hunt for an effective Covid-19 vaccine have fed optimism over the global economy, rekindling interest in some riskier investments. Emerging market currencies and stocks have been big winners, rallying hard for the past two weeks, while bonds have also made up lost ground. The broad-based rally took MSCI’s benchmark EM stock index into positive territory for the year, up more than 50 per cent since its March low.
And as Wall Street sets out its big ideas for 2021, EM is top of the list.
One in two fund managers in this month’s Bank of America survey picked emerging markets as their favourite for 2021. The sector will move “from resilience to outperformance” next year, Goldman Sachs analysts predicted. Renaissance Capital — an emerging and frontier market specialist often wary of making bullish calls — advised investors “to buy anything and everything” in the sector.
Nick Robinson, investment director for emerging market equities at Aberdeen Standard Investments, said a recovery in economic activity may not even be needed to keep the EM equities rally running.
“Economic growth is always helpful but sometimes you just need valuations to have diverged too much,” he said. “You also need a catalyst, which so far has been the news about vaccines and investors starting to price in a return to normality.”
Investment flows tell the same story. EM equity funds, which suffered almost uninterrupted outflows from March to September, have attracted almost $14bn in the past two weeks, according to data provider EPFR. This is mirrored by IIF data on cross-border flows, showing more than $22bn moving into local stock markets so far in November. Investors have also returned to EM debt, especially sovereign bonds issued overseas in dollars or other “hard” currencies.
Goldman Sachs’ bullish view is based on its forecast of a strong global economic recovery over the next 12 months, helping EM in particular given the “snapback potential” presented by low valuations. It picks out Mexico, which the bank thinks will benefit from a strengthening US economy, as well as having room for further policy easing next year to support growth, and Brazil, which it thinks could be lifted by rising commodity prices.
A big divergence within EM equities made a broad-based call difficult, said Mr Robinson at Aberdeen Standard. Nevertheless, he expected the sector to benefit from a rotation out of highly priced growth stocks that dominated the US Nasdaq index, into so-called value stocks: unloved shares often found in economically sensitive sectors such as energy and financial services.
“Part of the growth stock rally was driven by the idea that the future is arriving sooner, with everybody moving online and working from home,” said Mr Robinson. “Now there’s a vaccine, the future has been pushed back out a little.”
Renaissance Capital’s Charles Robertson points out that, as a lot of money now comes into EM assets through exchange traded funds, lower quality assets are likely to bounce the most, including lower-rated sovereign bonds, undervalued commodity currencies and relatively unloved or illiquid equity markets. He suggests buying a basket of African foreign currency bonds, such as those of Egypt, Kenya, Ghana, Nigeria and Angola.
Like others, however, he says a weaker US dollar is fundamental to the EM investment case. Some analysts expect the dollar to fall by as much as 20 per cent next year against the currencies of its main trading partners. That would provide a huge underpinning for emerging market assets. A weakening dollar offers foreign investors the prospects of currency gains on top of often generous equity dividends and higher interest rates on local currency bonds than those available in their home markets.
A weaker dollar also makes it easier for debtors in the developing world to repay their dollar borrowings, easing concerns about debt sustainability, and boosts earnings for commodity exporters as contracts priced in dollars become more valuable in local currencies.
However, if the dollar fails to weaken as expected, the investment case risks falling apart. “I think the dollar will be a fundamental driver,” Mr Robertson said. “But yes, it’s a big risk.”
That is not the only concern. Some EM-watchers are anxious about the rising overall debt burdens of countries that have spent their way out of the coronavirus crisis. Others are nervous about a repeat of 2013’s “taper tantrum”, when the US Federal Reserve announced a coming reduction in its bond-buying programme, and sent EM assets into freefall.
“I am worried about what happens when the market starts to think about tightening of policy again and all the stimulus that could be withdrawn,” said Aberdeen Standard’s Mr Robinson. “With a reduction in QE and an eventual raising of interest rates, you can imagine something like 2013.”