A commentary released Monday by PIMCO asks, “Are emerging markets ready to lead the global economy?” Lupin Rahman, portfolio manager, predicts emerging markets will outperform advanced economies over the next three to five years.
Rahman (left) said in the commentary that growth is expected to average 6%, compared with developed markets’ 2% growth rate. In Latin America and emerging Asia, in particular, growth should be between 6% and 7% with “low leverage, strong structural demand for commodities and a soft landing in China.”
She noted that countries in emerging Europe, especially those with high levels of leverage, can expect growth of 4%.
“The relevance of this increasing importance of EM for investors lies in the remarkable divergence between current investor positioning and the economic realities of the post-crisis world,” Rahman said, adding that global investors are “significantly underweight” emerging markets relative to their share of the world economy.
Rahman pointed to two major shifts in inflation in emerging markets: falling levels of inflation, and decreased volatility. She predicted that the current 2- to 3-percentage-point differential between emerging and developed markets will likely continue.
Most importantly, she said, is that a sharp increase is not likely. “Of course there are risks to this baseline view from potential spikes in commodity prices and asset-market bubbles,” she added, “but the fundamental shifts in inflation expectations mentioned before provide EM policymakers room to maneuver in tackling these shocks.”
Those policymakers are concerned about asset-market bubbles, and are relying on reserve requirement increases and macroprudent measures to combat inflation. Furthermore, several markets have allowed their currency to appreciate in order to lower price pressures from imported goods.
Other measures from central bankers include policy rate hikes and fiscal consolidation. The challenge, and it’s one Rahman claimed they are well-positioned for, is to remain ahead of inflation expectations and retain credibility regarding their objectives.
The majority of emerging market currencies are undervalued and will remain so, according to Rahman. She expects Asian countries to allow faster nominal appreciation, but predicts resistance in currency appreciation in Latin American countries.
A key part of shifting to the “New Normal view of the world,” Rahman said, is to move from a tactical allocation of emerging markets to making them an integral and increasing component of strategic allocations. Rahman recommended bonds denominated in local currencies, as well as U.S. dollar-denominated debt of emerging market sovereigns and corporates.
“To be sure,” Rahman concludes, “investors are likely to see some volatility along the journey to our secular destination of the New Normal. Also, the increase in global investor interest in emerging markets could mean valuations become relatively stretched at times. Overall, however, given their strong economic fundamentals and increasing global role, we believe emerging markets offer a compelling secular story.”