Fixed income
26 Jun 2018 | By Mark Nash

Calmer Waters

We believe that the beaten up valuations in emerging markets are starting to look interesting

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Markets got off to a shaky start in 2018 as investors worried that creeping inflation pressures would force the US Federal Reserve to raise interest rates just at a time when profits and growth were starting to peak around the world.

We take a more positive view on the global outlook.

We believe that the goldilocks scenario for markets is still in play, where growth is neither too fast to spark rampant inflation nor too slow to send economies into a recession. Inflation will rise, but not at a pace that will force central banks including the Federal Reserve to act more aggressively as the recent price action would suggest.

Policy makers, in our view, will take a more gentle approach as they gradually bring interest rates back up to more neutral levels. This should help to stem further market turbulence.

Emerging Markets Hit

Risky markets were hit by the perfect storm in the first half of the year – a strong US economy, a tightening Federal Reserve and a ramping up  of debt issuance by the US Treasury. While the subsequent funding squeeze and aggressive rise in yields has taken its toll on most risk assets, emerging markets in particular felt the full brunt.

The stronger US dollar has also not helped. It weakened emerging market currencies and affected economic growth data, prompting investors to pull capital.
 
The good news is markets, we believe, are headed for calmer waters. The full impact from the surge in US yields is starting to wane and the strength in the dollar should moderate as the economy slows. Outside of America, growth is still in good shape.

Buy Signal

We believe that the beaten up valuations in emerging markets are starting to look interesting. We have gradually increased our risk budget to emerging markets and added to our positions in both local and hard currencies. Emerging markets, in our view, are a good place to add alpha in the portfolio.

Despite buying into the weakness, we do not feel that emerging markets have hit the bottom so there could be further declines. Confidence remains fragile, largely due to the extreme market volatility, but global trade concerns and geological risks also loom large. Still, valuations look a lot better and should our forecast on a weaker US dollar prove correct, emerging market balance sheets will start to look attractive again.

The last piece in the puzzle for a full recovery, however, is a synchronised upswing in global economic growth. Only then will investors become truly comfortable investing in the sector. This is the final piece that is missing. Once we get that dynamic, watch emerging markets rally.

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