Re-Emerging Markets

After years of underperformance versus developed markets, emerging market equities and debt in 2017 are repeating their strong 2016 performance.¹ The last several months have included a reversal of the sharp, brief “Trump tantrum” of losses and outflows following the US election, and a wider recognition that emerging markets may have turned a corner.

We think the pattern can continue. We look to improving fundamentals across emerging markets (EM) as a catalyst for performance beyond short-term headlines, even as the potential rise of a newly protectionist US policy regime bears watching.

Dissipating headwinds

For years, emerging markets have been mired in concerns over challenging fundamentals, rich valuations, and macro imbalances. Many such headwinds have dissipated. Current account balances have improved and commodity prices have stabilized. Financial conditions have loosened in support of economic growth. Inflation appears contained at sustainable levels, having dropped from an average of 4.9% at the time of the “taper tantrum” in Q2 2013 to 3.8% as of the end of 2016.²

Corporate earnings across many emerging markets countries appear to have reached an inflection point. Negative earnings revisions slowed substantially during 2016 and earnings per share and estimates call for low double-digit growth during 2017.³ We observe these changes as a signal of EM equity markets cycling once again through four phases: despair, hope, growth and optimism. We think today’s transition could push emerging markets into a growth phase, wherein persistent earnings momentum serves as the catalyst for equity performance. The equity landscape across EM features relatively low valuations – EM as a whole continues to trade at a roughly 30% discount to developed market counterparts on a cyclically-adjusted-price-to-earnings ratio basis.⁴

EMD: No re-rating on US rates

The story in dollar-denominated EMD has been a parallel deflection of similar macro worries. EMD spreads have widened versus the 10-Year Treasury; such discounts historically have been supportive of higher total emerging market returns. One twist for debt has been the impact of rising interest rates. At a time when an estimated $8 trillion in global fixed income instruments offer negative yields, the relative richness of EMD yields (often well above US investment grade corporates and global bonds) would seem attractive.⁵ Investors may fear the impact of rising US rates on EMD. However, as the chart below shows, EMD assets have historically performed in periods of rising US interest rates.

Exhibit 1: Emerging Market Debt and Rising Rates: The Historical Record

Source: Bloomberg, JP Morgan, and GSAM. Analysis from October 31, 2001 – October 30, 2016. Chart shows EMD returns during rising rate periods, where US Treasury yields rose more than 75 basis points over the same period. GROWTH OF $100: A graphical measurement of a portfolio’s gross return that simulates the performance of an initial investment of $100 over the given time period. The example provided does not reflect the deduction of investment advisory fees and expenses which would reduce an investor’s return. Please be advised that since this example is calculated gross of fees and expenses the compounding effect of an investment manager’s fees are not taken into consideration and the deduction of such fees would have a significant impact on the returns the greater the time period and as such the value of the $100 if calculated on a net basis, would be significantly lower than shown in this example. Please see end disclosures for additional definitions. Past performance does not guarantee future results, which may vary. Diversification does not protect an investor from market risk and does not ensure a profit.

Buyers on weakness

Our GSAM PRISM™ portfolio analysis tool has found that many investors remain underweight EM in their strategic allocations. We are watching the populist rhetoric and potentially populist outcomes of Trump’s “America First” platform closely. We think the possibility of protectionist policies is a risk worth watching. Tariffs on Mexico or China could trigger retaliation; currency volatility could offset some of the positive trends reviewed above. Even considering these risks, we think that campaign rhetoric and headlines often read worse than the actual policy implementation, and we would view weakness in either EM debt or equity as a potential opportunity.

We are also mindful of the heterogeneity of the emerging markets complex: No two EM countries are precisely alike. The impact of policy and macro trends may vary. For these reasons we emphasize security selection in our monitoring of what we see as a series of encouraging EM trends.

Candice Tse is Vice President, Strategic Advisory Solutions, and James Ashley is head of the International Market Strategy Team, Strategic Advisory Solutions, Goldman Sachs Asset Management.

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ABOUT THE AUTHOR

Candice Tse

Vice President, Strategic Advisory Solutions, Goldman Sachs Asset Management

James Ashley

Head of the International Market Strategy Team, Strategic Advisory Solutions, Goldman Sachs Asset Management

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