CIO foresees a weaker USD and flat-to-slightly lower US Treasury yields by year-end, as US interest rates peak and its growth differential to the rest of the world fades. (ddp)

But we remain positive on the outlook for both EM equities and bonds. We see four reasons to put money to work in emerging markets at present.

EM growth may outpace developed markets thanks to a more advanced policy cycle. From the second quarter onward, market consensus expects EM growth rates to accelerate relative to developed markets (DM). And EM purchasing managers’ indexes (PMIs) are already recording a stronger rate of expansion than DMs. Many EM central banks raised policy rates quicker than DM counterparts to check rising price pressures. Prior policy decisions are bearing fruit. One example is Brazilian inflation falling to 4.7%in March (the first reading within the central bank’s target for more than two years).

Global drivers should turn from headwinds to tailwinds for EM. US government debt costs, which affect EM issuers’ ability to service USD debt, have fallen as market focus shifts from inflation to growth and financial stability. US 2-year and 10-year Treasury yields lie 100 and 62 basis points below their 2023 highs, respectively. We foresee a weaker USD and flat-to-slightly lower US Treasury yields by year-end, as US interest rates peak and its growth differential to the rest of the world fades. Historically, these developments have supported EM assets.

China’s economic recovery should translate into stronger earnings and performance. First-quarter GDP growth of 4.5% surpassed both market expectations and the fourth quarter print of 2.9%. Consumption data imply China’s domestically focused recovery is on track—March retail sales hit a near two-year high of 10.6% year-on-year growth. And China’s property sector is showing signs of improved sentiment (construction PMIs have bounced) and activity (y/y growth rates in property sales are now flat).

Our growth forecast of at least 5.7% exceeds the government’s 5% target, and we see overall earnings growth of 14% for Chinese equities. Chinese companies comprise 32% of the MSCI EM Index, so EM equities should be well-supported. Other ways to position for China’s recovery include the Australian dollar, commodities, and select European beneficiaries.

Valuations across equities and fixed income under-price improved fundamentals. EM equities trade at 11.6 times 12-month forward earnings, below the 10-year average and at a significant discount to our least preferred US equity market (18x for the S&P 500, the highest in about a year). Meanwhile, forward earnings prospects for EM equities should continue to improve, driving positive performance over the next 6–12 months.

Our most preferred stance on EM bonds is helped by higher starting yields (8.8% for sovereign US dollar debt) and appealing valuations. Today’s yield pick-up of nearly 500bps over the US Treasury curve can make a significant contribution to investors’ ability to generate portfolio income, especially if held over longer investment horizons.

EM bonds also look fair to attractively valued when adjusted for credit quality and likely recovery values: On this basis today’s 225bps risk premium for EM sovereign bonds over US Treasuries, about 25bps above the 10-year average, implies that investors are more than compensated for underlying credit risks. Historically, buying EM sovereign bonds when risk premiums are elevated has led to above-average returns over a 6–12 month investment horizon.

For more details, please see Investment strategy insights: Ten reasons we like emerging markets” (published 21 April 2023).

Main contributors - Mark Haefele, Matthew Carter, Michael Bolliger, Vincent Heaney, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Why invest in emerging markets right now?, 25 April 2023.