Why an emerging-market rebound appears elusive

The odds of an economic revival in China and a US Federal Reserve pivot this year are underpinning hopes of emerging-market bulls. The stage is set, they say, for a much overdue broad rally in the asset class.

Just don’t go all in yet.

Emerging-market equities were on track to enter a bull market while currencies on Monday rose to their highest since June, extending their best quarter since 2020. But there were some serious pockets of stress: Egypt’s latest devaluation signalled a fresh bout of volatility for its currency, while the Turkish lira reached an all-time low. Brazil faced turmoil too, with yields on its dollar bonds rising after supporters of former president Jair Bolsonaro stormed the nation’s capital on Sunday, challenging the new leadership of President Luiz Inacio Lula da Silva.

Brendan McKenna, a New York-based emerging-markets economist and foreign-exchange strategist at Wells Fargo Securities, is a believer in the asset class’s potential to outperform this year. The ability to tolerate pain in the short term, however, is needed. The best approach is to be “tactical and selective”, he said.

The short-term pain to which Mr McKenna alludes, particularly for emerging currencies, comes in part from the lack of clarity on the Fed’s path for interest rates. If anything, he said, the Fed is likely to keep raising interest rates, “eventually delivering more tightening than what financial markets are priced for”.

Should the Fed overdeliver and equity markets remain volatile, Mr McKenna is betting on outperformance in currencies associated with strong fundamentals, such as China’s yuan. He also likes those with still-hawkish central banks, such as the South African rand and Israel’s shekel.

Fragile currencies such as the Egyptian pound and the Turkish lira, meantime, may struggle, he said. In Colombia, a dovish central bank could also cause downwards pressure.

For some investors in riskier developing-economy assets, it’s not enough for the US central bank to pause rate hikes. It also needs to indicate it is about to start cutting them.

A strong signal will come from the US bond market: the steepening in the Treasury yield curve. That occurs when shorter-dated securities — the most sensitive to changes in policy — gain, pushing their yields down by more than those at the long end.

“At some point, a slower pace of monetary tightening would not be sufficient to extend the tactical rally into the medium term,” said Witold Bahrke, a Copenhagen-based senior macrostrategist at Nordea Investment. “We would need more tangible signs of a Fed pivot, ie, outright easing of monetary conditions.”

Mr Bahrke is looking for the gap between the two and 10-year maturities to widen to about 50 basis points, from about minus 70 basis points on Friday, before turning outright bullish on emerging markets. Developing-nation assets will lead a rebound in global markets once bulls start to dominate again, he said.

For Eurizon SLJ Capital money manager Alan Wilson, the Fed may pivot over the coming months, just as a policy-driven growth acceleration in China boosts demand for developing nations’ goods.

Local-currency debt — augmented by a buoyant outlook for developing currencies — will lead the way, followed by external debt, Mr Wilson said.

Of course, nothing is certain. After raising rates at the fastest pace since the 1980s, Fed officials issued an unusually blunt warning to investors, warning in recent meeting minutes against underestimating their will to keep interest rates high for some time.

Still, investors point out that developing-nation central banks have led global rate rises, helping to build a buffer against higher US real rates. Valuations are also attractive, particularly when growth differentials are factored in.

Economists surveyed by Bloomberg project that the rate at which emerging markets grow faster than developed markets will increase by seven times to 3.5 percentage points this year. Should the US slip into a recession, investors chasing growth may have little doubt as to where they must go.

Emerging markets are also at an advanced stage of pricing risks. About $170 billion of portfolio money fled emerging markets between February and October, the longest and largest outflows since the global financial crisis, according to Deutsche Bank. About $104 billion accounted for the exodus from China’s local bonds and another $57 billion from North Asian equities, the bank said.

“If you’re underweight, you’ll never time the bottom. So, you could gradually add exposure since EM assets — from debt to equity to FX — are cheap, historically, by many metrics,” said Peter Marber, head of emerging markets at Aperture. “A recession in the US most likely will be shallow, and if anything, could lead to lower rates — all of which will likely keep propelling EM asset prices.”