The past year has provided fertile ground for most asset markets, and emerging market debt (EMD) was no exception.
Volatility was meagre, global growth was present, inflation failed to pick up to a damaging level, and all this supported emerging markets (EM) in continuing on a strong trajectory. We do not expect things to be too different this year.
Global growth is still strong and shows no signs of abating, with economic data continuing to improve across all markets. Our own proprietary economic health indicator shows the the four largest economies re-approaching pre-crisis levels.
As a result, we raised the probability markets will price in above-trend growth from 65 per cent to 70 per cent, and, at the same time reduced the near-term probability of recession to zero (from 5 per cent). This recognises that the flattening yield curve continues to be a function of low inflation and continued global quantitative easing, not recession.
But as the global central banks gradually take a step back from monetary easing policies and the Federal Reserve starts to unwind its balance sheet at a faster pace, financial conditions will tighten - thankfully not to levels that would lead to an EM sell-off.
But, investors will need to remain flexible when the investment environment changes, and having an overall flexible fixed income approach can help insulate investors. This may include considering exposure to selective sectors in EMD like local currency debt, and high-yield sovereign and corporate bonds which offer the best exposure to the economic backdrop, while providing attractive valuations.
The good news is that growth is expected to remain a positive driver behind the investment case for this asset class. Major EM countries such as Brazil, Russia and South Africa are finally recovering from severe recessions in 2015-2016 and as a result total EM growth is not only forecast to increase, but should been seen more evenly across a greater number of regions.
Importantly, while developed market growth troughed later in 2012, emerging markets continued to slow for another three years and only started to turn around in 2016. As a consequence, developed markets are entering late stages of the economic cycle, whereas emerging markets are still in mid-cycle stage. This year, EM GDP growth is expected to accelerate to 4.9 per cent while developed market GDP growth is forecast to stall at 2.3 per cent.
Buyers beware
But let us not be complacent. There are challenges investors need to be wary of. Higher inflation is on the cards for most EM countries which could cause pressures, most notably in China, India and central eastern Europe. Across emerging markets, it is likely to rise from 4.2 per cent year-on-year in 2017 to around 4.5 per cent in 2018.
But at the same time, economists have generally over-estimated inflation's ability to rise. And while there are strong reasons to believe that there will be global reflation, other factors should continue to moderate overall higher inflation risks.
