The challenging environment for emerging markets is likely to stay with us for some months to come. Commodity and oil prices may remain under pressure, weighing on EM currencies and investor flows and sentiment. However, somewhere in the second quarter the oil price may start to recover somewhat as some improvement in the sup-ply/demand balance should become visible. Combined with a better visibility on the Federal Reserve’s monetary policy outlook this might lay the foundation for a tentative recovery in EMD. We also expect additional monetary and fiscal stimulus from China, which would be supportive to emerging market assets in general. Moreover, I think that a benign inflationary backdrop will allow for accommodative monetary policies to remain in place in a number of EM countries. That should be positive for growth as well. I do not expect EM growth to recover already this year, that will be more of a 2017 story. But, as markets are always anticipating, they could already start pricing in a recovery from the second half of this year onwards.
Obviously, risks keep surrounding the EM universe. Prolonged weakness in commodities, a stronger than expected Chinese growth slowdown, a disorderly Chinese currency depreciation, weaker than expected growth in the US, policy mistakes by the Fed and unexpected large corporate defaults are the main risks in my opinion. As we have seen in the first week of the year, markets are still concerned about China. I think that is bit overdone. The direction of the yuan should become more predictable in the coming months. Some gradual depreciation against the US dollar is to be expected as China’s monetary policy stance diverges from the US. But China is not about to embark on a currency war to stimulate its exports, as the move would not fit its policy of transforming the economy to a more consumption and services-based one from an investment and export-led model. Growth will also keep slowing down, to still very healthy levels though, which is part of the economy becoming more mature.
Although one might think the opposite, the Chinese debt market actually has performed very well last year, which could continue in 2016. An important reason is the attractive technical picture, as due to the change in expecta-tions from currency appreciation to depreciation, there is more demand for US dollar bonds and less supply. The whole Asian region is seen as a safe haven by bond investors, as the region is relatively insensitive to commodity prices and is also lacking political instability. Latin America, on the other hand, has suffered a lot due to its com-modity sensitivity and political issues. However, valuations have become very attractive and once commodities show signs of stabilisation, investors may start looking for value opportunities there.
Politics will keep playing a role in the region though, as Brazil keeps muddling through and the fiscal position further deteriorates. We keep looking at Brazil closely though, as a change in the political situation can unlock many opportunities. Argentina is a nice example of a government change in a positive way. The country is opening up again for investors which will entail a lot of opportunities.
We currently have a relative preference for hard currency debt over local currency debt. Within hard currency we prefer sovereign bonds over corporate bonds. Despite the challenging environment, expected returns for 2016 range from low positive single digit for EMD local bonds and Asian HC debt to 6% or more for EMD HC, EM corporate bonds and Asian high yield bonds.
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