Analysis: In emerging markets, the bulls are back

LONDON, Nov 23 (Reuters) – After some of the biggest losses on record this year in emerging markets, bulls are back, betting it is time for a rebound.

With warnings that global interest rates are stabilizing, China eases COVID restrictions and nuclear war is averted, investment bankers’ 2023 annual forecasts suddenly have some pretty high forecasts for emerging markets (EMs).

UBS, for example, expects emerging market equities (.MSCIEF) and fixed income to gain between 8% and 15% in total returns after plunging 15% to 25% this year.

A “bullish” Morgan Stanley expects a yield close to 17% on emerging market local currency debt. Credit Suisse “especially” likes hard currency debt, while BofA’s latest survey of global fund managers shows “long EM” is the leading “contrarian” trade.

“It’s kind of like total risk reduction,” said Samy Muaddi, EM portfolio manager at T. Rowe Price, who has started diving into what he describes as “well-anchored” EM countries like the Dominican Republic, Ivory Coast and Morocco .

“Now, I think the price is attractive enough to warrant a contrarian view.”

Soaring interest rates this year, the war in Ukraine and China’s battle with COVID have combined to be a wrecking ball for emerging markets.

It may be the first time in the asset class’s 30-year history that “hard currency” emerging debt – the type usually denominated in dollars – will cause investors to lose more than 20% on a total annual return basis and the first two-year streak of losses .

The 15% loss currently accumulated by local currency debt would be a record, while emerging market equities had only worse years during the 2008 financial crisis, the 2000 dotcom explosion and the 1998 Asian debt explosion .

“This has been a very difficult year,” DoubleLine fund manager Bill Campbell said. “If it wasn’t the worst, it’s one of the worst.”

Reuter graphics
Reuter graphics

It is the experience of those past defeats that has led to the current wave of optimism.

MSCI’s EM stock index soared 64% in 1999 and 75% in 2009 after losing 55% during the Asian and financial market crash. Emerging market hard currency debt also saw a whopping 30% rebound after the GFC fell 12% and local debt, which had lost just over 5%, jumped to 22% then 16% l ‘next year.

“There is a lot of value at today’s current levels,” DoubleLine’s Campbell added.

“We don’t think this is the time to blindly allocate into an emerging market, but you can start putting together a basket (of assets to buy) that makes a lot of sense.”

Reuter graphics

BROKEN CLOCK

Société Générale analysts said on Tuesday that cooling inflation and looming developed-market recessions were “hugely supportive of the outperformance of local emerging-market bonds.”

Most of the big investment banks, however, backed emerging markets to rally during this period last year. No one predicted a Russian invasion of Ukraine or soaring interest rates. There is an almost annual ritual of bankers talking about the possibilities of emerging markets, say those who have followed them for years.

BofA’s December 2019 investor survey showed dollar “shorting” was the second busiest exchange. JPMorgan and Goldman Sachs were bullish, while Morgan Stanley’s message at the time was: “I have to buy EM All!”.

The dollar subsequently rose nearly 7% and major emerging market stock and bond indexes lost money.

“You know how it works with a broken watch – it might be right at some point,” said Viktor Szabo, portfolio manager at abrdn EM.

Emerging market equities annual movements

REASONS TO BE CAUTION

In addition to the war in Ukraine, stubbornly high inflation and China’s lockdowns, rising debt and borrowing costs mean credit rating agencies are warning of rising risks of default in countries such as Nigeria, Ghana, Kenya, Pakistan and Tunisia.

Nomura forecasts seven potential currency crises, and while UBS is bullish on emerging market assets, it estimates this year has seen the largest depletion of foreign exchange reserves since 1997. His forecast for global growth of 2.1% would also be the most slow of the last 30 years, apart from the extreme shocks of 2009 and 2020.

“Our hope is that a looser Federal Reserve combines with a spike in the global inventory/recovery cycle in Asian tech since the second quarter, creating more fertile ground for emerging markets outperformance at that time,” UBS said.

If the outlook does indeed brighten, international investors are in a good position to pull back, having sold off emerging markets heavily in recent years.

JPMorgan estimates that about $86 billion of emerging market bonds have been dumped this year alone, four times the amount sold during the 2015 “taper tantrum” year.

“EM is swimming to safety,” summed up Morgan Stanley. “Though still in deep water.”

COVID Deterioration of emerging markets sovereign ratings

Additional reporting by Rodrigo Campos in New York; Editing by Elaine Hardcastle

Our standards: the Thomson Reuters Trust Principles.

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