Fund managers’ appetite for emerging market assets seen strong in 2018

Continued interest: Ongoing construction works near the KL City Centre. Malaysia’s equity and bond markets are expected to benefit from the sustained interest in emerging makets. — AZHAR MAHFOF/ The Star

PETALING JAYA: Global fund managers’ appetite for emerging market (EM) assets is expected to remain strong going into 2018 despite the credit ratings indicating a cautious mood ahead.

For instance, prominent asset management companies, such as BlackRock Inc, T. Rowe Price Group Inc and OppenheimerFunds Inc have voiced their optimism about the prospects of EMs, and indicated their continued preference to invest in the region next year.

And that’s good news for Malaysia, whose equity and bond markets are expected to benefit from the sustained interest in emerging markets.

Nevertheless, critics note a flight from risky assets – which encompass EM stocks and bonds – remains a possibility due to several prevailing risks that could shift investor sentiment.

Among other things, institutional investors seem to be wary of the debt sustainability and political uncertainties in EMs; risk of a faster-than-expected slowdown of China’s economy; overly hawkish monetary policy in developed markets; and an unexpected downturn in commodity prices.

According to an index compiled by the Institute of International Finance, sovereign credit ratings of emerging markets have been trending down in recent years. The index is now at its lowest level of 10.87% since 2010. In December 2012, the index stood at 11.29%.

The declining index, driven by sovereign downgrades of some emerging economies, including China and South Africa, as well as several downgrades of corporate ratings in EMs, reflects concern about the sustainability of the high debt levels of many emerging economies as well as their ability to refinance them as interest rates increase.

Another major concern pertains to political risks, as 18 emerging economies, including Malaysia, will be holding their elections next year. The risk of an unexpected outcome could raise the spectre of the markets punishing political uncertainty in the particular country.

Other looming risks include a potential sharp slowdown in China posing risks to the entire Asian region as well as concerns about rising interest rates in developed markets potentially leading to capital outflow and a renewed weakness in commodity prices triggering a sell-off in risky assets.

However, fund managers still see emerging market assets as a good buy in 2018 due to improving fundamentals.

BlackRock, for one, sees emerging-market stocks outperforming again next year on rising profitability, higher valuations and investors returning to the asset class.

It rates emerging-market equities as “overweight”, noting economic reforms, improving corporate fundamentals and reasonable valuations as well as above-trend expansion in the developed world as the positive factors, but considers a sharp rise in the US dollar, trade tensions and elections as potential risks.

“We see scope for more emerging market rerating in 2018, whereas the US and Europe have much less headroom. Other reasons to like emerging markets: reform progress in key markets and plenty of capacity for investors to increase exposure after years of underweighting the asset class,” BlackRock said in a recent report.

“We see the greatest opportunities in EM Asia, but note positive progress in Brazil and Argentina... We do not see moderate Fed tightening or US dollar gains harming the investment case,” the fund manager, which has US$5.7 trillion (RM23.26 trillion) assets under management, added.

On Asian equities, in particular, BlackRock also has an “overweight” rating, citing the encouraging economic backdrop.

“China’s growth and corporate earnings appear solid in the near term. We like selected South-East Asian markets but recognise a faster-than-expected Chinese slowdown would pose risks to the entire region,” it explained.

BlackRock is neutral on emerging market and Asian bonds.

“Sustained global growth benefits emerging market debt, alongside a benign inflation backdrop in many economies. High valuations make further capital gains less likely, leading us to focus on the benefits of relatively high income,” BlackRock said, adding that steady global expansion and positive corporate fundamentals should support the region’s credit.

“We favour high-quality corporate debt in China and India. We have a selective stance on high yield, but see opportunities in Indonesia and China,” it said.

Meanwhile, T. Rowe Price continues to see attractive opportunities in emerging markets amid a supportive growth backdrop, attractive relative valuations and continued reforms.

“Global EMs continue to offer attractive investment opportunities even after the strong performance seen in 2017. Many of these markets are in much better shape today, boosted by the ongoing progress of meaningful economic and political reforms in key developing countries. Many of their traditional vulnerabilities, such as large current account deficits and low inflation-adjusted interest rates, have markedly improved,” T. Rowe, which manages around US$810.8bil in assets under management, said.

According to T. Rowe, while valuations for both equities and bonds in EMs are not as compelling as they were a year ago, following 2017’s strong performance, these risky assets “remain attractive relative to their history and to most developed markets”.

“Importantly, they do not reflect emerging markets’ contribution to the global economy and to overall growth. In fact, we would view a pricing dislocation triggered by an event in developed markets as an opportunity to broadly add to emerging market debt at lower valuations,” it said.

T. Rowe said while geopolitical tensions involving North Korea continue to present a risk, stable growth in China has been a key factor in supporting the rest of the EMs, particularly the Asian economies that are closely linked to the Chinese supply chain.

It noted that while unexpectedly hawkish monetary policy in developed markets would likely lead to some volatility, it views EMs as being relatively well positioned to maintain stability in an environment of gradually higher interest rates, primarily due to healthier current account balances and more prudent fiscal positions.

“Furthermore, inflation-adjusted interest rates in some EMs remain high, giving their central banks the flexibility to lower rates if necessary,” it said.

Similarly, OppenheimerFunds holds the view that EM equities will outperform developed market equities, while EM local bonds will offer a better risk and return profile than US corporate bonds.

Valuations aside, Oppenheimer-Funds notes that leading indicators of the broad EMs, as represented by the Composite Purchasing Mana-gers Index, are improving. These are typically a harbinger of sound equity returns.

The case for emerging market sovereign and corporate bonds is also sound, according to Oppen-heimerFunds.

“Real yields remain attractive across the region, suggesting capital flows will continue to be positive even in the event of a series of Fed rate hikes. The economic backdrop is as good as it has been in a number of years and monetary policy will likely remain accommodative across much of the EMs as inflation has been falling,” Oppenheimer-Funds, which has more than US$247bil in assets under management.

“The currencies – the 2017 rallies in EM currencies notwithstanding – remain cheap to the US dollar on a purchasing power parity basis, providing another potential lever for total returns,” it added.