By Matt Linsey, head of emerging markets at DWS There are many reasons to have renewed faith in...
By Matt Linsey, head of emerging markets at DWS
There are many reasons to have renewed faith in emerging markets. Emerging market bond yields have been driven down by strong demand from investors who have seen falling global interest rates reduce their returns. Falling bond yields have cut the cost of capital dramatically, great news for business. What is more, it could prove sustainable, as below trend growth and rising unemployment in the developed world make higher interest rates unlikely.
At the same time, the US appears to have abandoned its strong dollar policy as it fights to reflate its struggling economy. Historically, falling risk premiums and dollar weakness have been very bullish for emerging markets. However, a clearer picture of the global growth outlook is necessary to determine the sustainability of any rally.
In addition, there are always risks when investing in emerging markets, not least due to financial imbalances.
Most emerging market countries however are now running fairly sizeable trade and current account surpluses, reducing the risk of currency or debt crisis. And now that almost all emerging currencies are floating, these countries are better placed to adjust to dollar weakness.
It is vital for investors to realise that the performance of individual emerging market countries is likely to be disparate. For example, Brazil and Russia have benefited recently because they have not been dogged by concerns of over-capacity and diminishing nominal earnings growth.
Brazilian bonds have seen a spectacular rally, the trade surplus is at its largest since 1994, and positive pension and tax reforms are likely to be passed over the next few months. In addition, domestic interest rates are on their way down.
However, Russian equities no longer trade at a discount to other emerging markets and, in some cases, valuations are at a premium. While higher growth prospects justify this to an extent, the catalysts to drive valuations higher are missing.
In contrast, we believe Turkey has more immediate upside potential. Most of the banks still trade at around book value, while there is further room for domestic interest rates to fall as inflation falls in the face of currency strength.
Our favourite market, however, is India. While it has disappointed over the last few months, domestic interest rates are falling, earnings growth remains strong, foreign exchange reserves are at record levels and valuations remain attractive.
There can be little doubt that China has suffered as a result of its inability to bring Sars under control. While it is clear that this has had an adverse short-term impact on the economy, it is impossible to determine the impact on domestic consumption and foreign direct investment over the medium and long term. However, attractive valuations foster our neutral stance.
The prospects for Korea are fairly balanced between positive (low valuations and falling interest rates) and negative (rising non-performing loans and corporate governance concerns) factors.
The cost of capital has fallen dramatically.
Valuations are attractive.
Dollar weakness is good for the asset class.
Many markets have rallied strongly.
Performance in the asset class may diverge.
Corporate governance and liquidity a problem.
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