Opportunities hidden in EMD can add to investors’ portfolios

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This is a sponsored article from NN Investment Partners.

The outlook is certainly positive for EMD, which has performed well this year. The asset class has benefited from US bond yields declining, the dollar’s weakness and also from an improving growth outlook, healthy current accounts, falling inflation, high real interest rates and undervalued currencies.

The EM environment looks even better now, as China has surprised on the upside, with very decent growth figures in the past few quarters. Industrial metals have recovered strongly since 2016. The oil price has been quite volatile, but oil demand remains benign, which is an indication of solid global growth.

Undervalued EM currencies have room to appreciate

A key question is whether global economic growth will break through the ceiling of the past six years. Our base case is that global growth will continue to remain range bound around current levels. This scenario is very positive for EMs as global liquidity and financial conditions would remain very supportive on the back of Central Banks gradual move towards policy tightening and inflows would likely persist, helping EMD spreads to tighten further, both in the sovereign and corporate space.

As EMD offers higher yields generally, it tends to outperform all other fixed income asset classes in the long term, in both hard (HC) and local currency (LC) strategies. In a range bound economy, this means further spread compression for HC assets, especially the higher yielding part of the universe – the so-called Frontier Markets.

In particular, LC debt deserves a closer look: although EM currencies have appreciated this year, they are still undervalued by about 15%, according to our estimates. Investors could see their returns enhanced if EM currencies regain even some of the ground they have lost over the past five years. Furthermore, real interest rates are currently high in EMs and there is scope for central banks to cut rates as inflation remains benign. This will reduce yields and raise capital values of bonds. Countries that look attractive in these terms include South Africa, Russia, Turkey and Brazil.

Good opportunities

EM countries have much healthier balance sheets now than in the past. Many major EM countries that ran current account deficits in the taper tantrum of 2013 are now running surpluses. This makes them less dependent on external financing and less vulnerable to external shocks providing a strong cushion in an environment of globally-rising interest rates and a potentially stronger dollar.

Economic growth in EM economies has now stabilised amid relatively high real interest rates, undervalued currencies and stable-to-improving commodity prices. This positive combination of factors means that investors looking to balance their portfolios against the potential headwinds created by normalising monetary policies and rising interest rates should broaden their search to these often-ignored or under-invested assets, irrespective of whether the global economy remains range bound or breaches its current ceiling.

Performance of EMD Hard and Local Currency benchmarks (in USD)

Over the past 12 months, all of the EMD sub asset classes performed well and overall delivered strong returns despite the US Treasury sell-off in November 2016.

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This is a sponsored article from NN Investment Partners.