There has been a mood shift in emerging markets over the past 6 months as the fear that gripped investors in the early part of 2016 washed away with the recovery in sentiment and risk appetite.
Yet even after solid gains, the “mood is turning more constructive for investing in emerging markets,” says Michael A. Gomez, PIMCO’s head of emerging markets portfolio management, and a number of his senior colleagues in a post on PIMCO’s blog.
Not only is the mood improving but the “fundamentals warrants a more optimistic approach to investing in emerging assets,” PIMCO says.
Gomez and his colleagues cite a number of fundamentals which have improved which read like an alignment of the planets for emerging markets investment.
“USD strength has abated, commodities have stabilized and the outlook for China, while bumpy, is one of muddle-through, not hard-landing,” the company says.
Importantly it’s not just the macro backdrop but country specific factors which are also improving.
The big fall in emerging market currencies, which PIMCO says overshot fundamentals, was important in “helping kick-start meaningful adjustments in macro fundamentals across EM economies”.
That means “growth is accelerating with high-frequency variables pointing to stabilization and forward-looking indicators,” PIMCO says.
There are no inflation pressures and the currency adjustments mean that where previously markets worried about external balances in many emerging market countries, there is a clear improvement in these balances.
That is the J-Curve is at work, with initial reaction to a weaker currency of import contraction now transitioning with “improved competitiveness and higher export volumes”, improving the outloook and further aiding the sectors balance.
PIMCO says political uncertainty has reduced, corporate and sovereign balance sheet repair has been undertaken, and the recent resilience seen in the sector to outside shocks “reinforces the secular case for investing in EM”.
It’s an incredibly bullish thesis and one that is already attracting more attention, and investor capital, as developed market growth and potential returns languish, inhibiting returns.
But PIMCO is not gilding the lily. It says emerging markets are not without risks.
They say a renewed bout of global risk aversion could hit the sector. That’s especially true because “due to the compounding impact of concurrent shocks on EM (terms of trade, rates and FX), the beta of EM investments to global shocks has historically been higher than for other credit sectors”.
It’s not a trade for the faint-hearted.
But in the end, not only is PIMCO bullish on the sector outright, it believes that because emerging markets have been beaten down so badly the odds of outperformance are high.
“From a total return perspective, the carry cushion in EM bonds relative to DM means that the hurdle rate is high to underperform over the long term, particularly when the starting point is cheap valuations,” the company says.
You can read the full report here.