It’s no secret that emerging-market debt was decidedly out of favor in 2013. Ditto for equities — in fact, emerging-market stocks were among the worst performing assets last year, victims, like their bond counterparts, of currency depreciation following the widespread anticipation of potential tapering of bond purchases by the U.S. Federal Reserve.
Today, the surprise element associated with a change in the direction of interest rates is no longer an issue, and for most investors, it is a question of when interest rates will rise rather than if, says Vlad Milev, emerging markets strategist at investment firm Payden & Rygel. Many have priced in the risk associated with the Fed easing up on stimulus, and this means that “the markets have corrected and spreads on both foreign currency and local currency emerging-market debt are higher,” he says. “This year, we expect to see institutional investors either recommit to the asset class, or, if they’re already invested in it, to invest further.”
From a relative point of view, emerging market debt still is attractive compared to several other asset classes such as U.S. corporate debt. Many emerging-market countries are managing reasonable debt-to-GDP ratios, Milev says, and their overall growth rates, albeit lower than in previous years, are still favorable.
All the same, 2014 is not going to be an easy year for the emerging markets, largely because of a number of macro factors that will undoubtedly cause investors, particularly mutual fund investors, to hesitate in committing too significantly to the asset class, says Richard Segal, credit strategist at Jefferies in London.
Politics will be one of the key issues this year.
Several countries, including Brazil, South Africa, Turkey and Indonesia, have important elections coming up, Segal says, the outcomes of which could have implications for policy changes. Political tension is also rife in places like Ukraine, and India is battling a raft of problems, not least a challenge to its existing legal and social framework in the aftermath of the gruesome gang rape of a young woman on a New Delhi bus in December 2012.
Many nations also have large current account deficits, and some, like India, are running concurrent budget deficits, too. Financing these will be difficult, Milev says, but more than that, pushing through the kinds of structural reforms needed to buffer these economies and strengthen them from the inside for the long haul will be tough to do in an election year.
Of course, GDP growth forecasts for most emerging-market countries are still better than for their developed market counterparts: The World Bank expects China to grow by 8% in 2014, India by 6.5% and Brazil by 4%, and overall developing economy growth to top out at around 5.7%, an improvement over the 5.1% recorded for 2013.
But according to Clem Miller, investment strategist at Wilmington Trust Investment Advisors, GDP figures aren’t necessarily the best indicators of the health of emerging markets, particularly for equity investors. Although most developing stock markets have regained some strength in the past couple of months, and China’s even pulled ahead significantly after the Chinese government announced a comprehensive plan for financial sector reform, corporate sector growth, as measured by forward earnings per share, is stunted in many of these countries (forward earnings per share are much better for U.S. stocks, actually, than for most emerging markets) and likely to be so unless some serious reforms are made, Miller says.
Infrastructure is perhaps the greatest roadblock that all emerging markets face, and it’s a huge impediment to the future growth of the BRICs, in particular.
“Companies are holding so much inventory that can’t get anywhere because of the serious lack of infrastructure in these countries, and when you add up all the effects of that, it means less sales revenue that accrues in the bottom line and therefore lowers profits,” he says. “These countries need roads, ports, airports, you name it. And in India, there are massive power shortages that cause huge delays.”
Potentially, there’s another huge growth opportunity in emerging markets, Miller says, but for many countries, that will only come when companies are able to improve their earnings per share by making sure distribution capabilities can match production, and the “question is over what time period we’ll see that happen and whether that time period is relevant to investors.”
In 2014, the approach to emerging markets will be mostly about making the right country decisions, Milev says, and less about simply having exposure to the asset class, as has been the case in these past years.
The past year was “a wake-up call for many countries, based on the realization that the market won’t always be there to bail them out and that the liquidity that they’d relied on won’t always be available,” he says. “Emerging markets can no longer get away with just being emerging markets and will need to seriously work on making the necessary, underlying reforms to correct their weaknesses.”
Check out more 2014 outlooks on ThinkAdviso.
Check out Roubini: 6 Reasons BRICS Are Taking a Beating on ThinkAdvisor.