Emerging economies continue to recover. Growth momentum has been positive for more than a year now, and has accelerated in recent weeks. This is largely why the recent nervousness in financial markets over a possible accelerated tightening in monetary policy in the US and Europe has had little impact on emerging markets (EM).
EM bonds saw outflows for the first time this year, but yields hardly increased. At the same time, EM equities continued to attract new capital and the pace of the outperformance over developed markets accelerated.
In emerging markets, growth momentum has been positive since June 2016. Since then, the most relevant cyclical data in the 20 largest emerging markets have been improving. Initially, it was primarily export-related figures that improved. Commodity-exporting countries benefited the most from higher investments in the Chinese housing market and infrastructure.
By the end of 2016, the broad-based global trade recovery was the main driver of EM growth. And since spring, we have seen a clear improvement in domestic demand in almost all of the emerging countries. This is the result of the strengthening of credit growth for the first time in six years, largely due to rising capital inflows.
Stronger credit growth (from 6 per cent in January to 8 per cent now) should help to give the domestic demand recovery legs in the coming quarters. The growth recovery, which is not only stronger, but is also more broad-based with exports, investments and household consumption all contributing, is the main reason for the more favourable risk sentiment towards emerging markets.
This was reflected in the last week of June and the first weeks of July, when bond yields rose in Europe and the US, but it had little impact on bond markets in the emerging world. Given the strong inflow of new capital in EM bond funds over the last two years, and the fact that these products are traditionally sensitive to interest rates in developed markets, this is certainly worth mentioning.
Based on China’s most recent cyclical data, and credit data elsewhere in the emerging world, we may assume that EM growth recovery will continue in the coming months. This means the risk of large outflows from EM funds is likely to remain controllable even if interest rates in the US and Europe continue to rise.
Key points
Growth momentum in emerging markets has been positive for more than a year.
Based on China’s most recent cyclical data, we may assume that the EM growth recovery will continue.
EM bonds should be able to benefit from the improving growth prospects.
Still, in the current environment of strong EM growth momentum, and upward pressure on interest rates in developed markets, EM equities are clearly more attractive than EM bonds, as equities benefit more from accelerating growth and are less sensitive to the narrowing interest rate differential between EM and developed markets (DM).
After years of strong capital inflows, EM bond yields are also well below their historical average, while the valuation discount of EM equities relative to DM equities is close to its highest level since 2008. In 12-months forward PE terms, EM equities are around 30 per cent cheaper than developed markets (see the chart).
