The main changes in our asset allocation deal with emerging markets (debt, equities and currencies). It is therefore necessary to explain the rationale behind our asset allocation.
Let’s recall that the weakness of EMG asset classes for the past 4 years come from numerous factors:
As a consequence, capital fl owed out of EMG markets, and this “block” became a neglected asset class… and all international portfolios chose to underweight the EMG as standard policy. During this period, selectivity was key: it was better to prefer commodity-consuming countries, countries able to have autonomous growth, with low external debt and, if possible, undervalued currencies. As usual, in such cases, valuation turned excessively low for some equities/companies/debt/currencies.
Three key questions at this stage:
What are the prerequisites for EMG to be a success story?
Prerequisite #1: Fed policy has to remain accommodative/softer than generally thought
EMG markets are highly dependent on US rates, as seen again in 2013 and in 2015. EMG started to decline when rumours began about the end of QE and when the Fed announced its desire to hike interest rates. The Fed is now behind the curve and cannot tighten and restore its room for manoeuvre as it did in 2004-2006. As a consequence, the Fed should continue with a soft monetary policy, and QE4 if needed. On the other hand, central banks (ECB, BoJ, PBoC and the Fed) should continue to add liquidity, which represents a plus for EMG asset classes and risky assets.
Prerequisite #2: China: fears about growth and about the yuan are exaggerated
As seen above, China’s slowdown is a fact. No hard landing expected so far. China will not devalue the yuan, and China’s exchange rate policy is now stable. The Chinese central bank has recently changed the essence of its FX policy. PBOC has decided to manage the stability of the yuan vs. a basket of currencies. At the very least it is quite efficient. A stabilisation of growth and/or a decline in fears about China and the yuan (as is the case at present) represent positive messages for EMG asset classes.
Prerequisite # 3: oil prices and commodities prices do not decline further and start to recover
1st comment: economies are experiencing the biggest counter-shock in the past few decades, with positive impacts.
2nd comment: two thirds of the decline in oil price is linked to supply-related developments.
It explains why it is so difficult to predict the price, which adds another range of uncertainty and volatility.
3rd comment: the bulk of world production of commodities is no longer profitable. The next step has to be either a rise in prices or cut in supply, orboth.
In other words:
Prerequisite # 4: world growth does not fall further
World growth should be around 3%, both in 2016 and 2017, and no further slowdown or recession is expected. Russia and Brazil (at a later stage) should gradually exit recession, and GDP growth in EMG countries is expected to improve gradually.
Conclusion on prerequisites: with regard to the four prerequisites described above, EMG markets, both equities and debt, should be able to recover in 2016. When prerequisites are met, attractive key features of EMG markets will take the lead.
What are the key features of EMG countries at this stage?
1st key feature: EMG debt is seen as an oasis of rates and spreads in a environment of low/negative rates
Rates are negative in Japan all over the curve (except the 30 year bond, which is close to zero, though). 35% of Barclays Euro global aggregate index (sovereign, quasi-sovereign, corporates and financials) bear a negative yield at present, with a small proportion of yields above 2%. EMG debt still has attractive yields and spreads, which is a “plus” for investors still chasing yields and spreads.
2nd key feature: currencies are cheap, a reason to pay attention to EMG markets
The depreciation of EMG currencies started in 2013, when the end of the US QE was rumoured. Since then, all factors played for further depreciation (Russia, Brazil, China, CNY, commodities, Fed, world growth…). EMG currencies are cheap, with significant undervaluation in some cases. Switching from hard currency debt to local debt makes sense at this stage.
3rd key feature: FX regimes are flexible, a plus for EMG economies
EMG countries have adopted flexible exchange rates for some years. The depreciation of currencies has prevented severe internal devaluation (recession / depression) and favoured stronger recoveries. This is very different to past crises, when currencies began to depreciate in the last stages of the financial crisis, after economic activity collapsed.In other words, undervalued currencies are attractive.
4th key feature: debt in USD much lower than in the past
Any USD appreciation is not as disruptive as it used to be in the past. The structure of the debt has dramatically changed in the past 15 years, and
5th key feature: oil down, USD up…
All in all, it is not as bad as generally thought for oil producers with flexible FX rates.
Conclusion on key features: in the past 3.5 years, EMG market asset classes have been completely neglected, due to the objective factors mentioned above and due to overestimation of some risks and fears. As is always the case with neglected asset classes, international portfolios are underweighted EMG markets, and valuations offer attractive entry points. While prerequisites are met, key features offer strong advantages.
How to invest in such heterogeneous asset classes?
The term "emerging markets" is unsatisfactory. It's misleading, because it tends to group countries together that have very different economic features and realities. What's more, it doesn't recognise the spectacular progress made by some of them. Finally, some of these countries are now in much better positions than so-called "advanced" countries. In fact, both "emerging country" and "advanced country" are confusing. This is especially unfortunate in the current situation, which requires, and even demands, a relative value analysis, off benchmarks, so great are the discrepancies and so dissimilar the countries' features.
There are several traditional ways to invest in EMG markets:
Traditional way # 1: the bloc approach
This approach opposes EMG bloc and Advanced countries. This split is completely out-dated and has been so for a long time. The discrepancies and differences call for more detailed analysis. In times of crisis, the EMG block is a block, but in quiet periods, when investment in these countries is appropriate, it is not a block anymore: specificities, thematic, valuation gaps… drive the recovery. Moreover, some so-called EMG countries are in a better shape than some so-called advanced countries.
Traditional way # 2: the regional approach
This approach is inadequate even though there are common features: With commodity-hungry Asia, oil-producing GCCs, and EMG Europe stuck to the EU… moving from one region to another in terms of investment isn't bad, but we can do much better.
Traditional way # 3: Benchmark/index and Sub-index approach
This approach forces to adopt concepts such as BRICS (Brazil, Russia, India, China and South Africa), Next11 (countries following BRICS, such as Turkey, Indonesia, Mexico, Philippines, Vietnam), New Frontier (25 countries considered to be the next wave of emerging countries such as Bangladesh,
The Amundi approach: a “factor-investing” classification
We have published several studies (in 2012 and 2014), in the Cross Asset Investment Strategy Monthly in particular. Let’s recall the basic components:
Our approach is more interesting than traditional approaches for several reasons:
The purpose of our approach is at least twofold;
The international context allows investors to gradually come back into EMG asset classes, and to pay attention to their current (under) valuation. 4 comments to conclude:
Our asset allocation recommendations are unchanged this month. The table next page summarize our views, convictions, and positions.
In the past few years,
A stabilisation of growth and/
EMG debt still has attractive
International portfolios are