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We’ve preferred Emerging Market (EM) debt to Developed Market (DM) long-term peers for some time. We went tactically overweight EM local currency debt in March, picking up higher yields for carry and benefiting from a broadly weaker U.S. dollar plus tightening spreads this year (yellow line in the chart below). Higher EM yields remain attractive, but tightening spreads with Treasuries (pink line) lead us to consider switching to hard currency peers typically issued in U.S. dollars (orange line).
But peaking DM policy rates should support EM currencies, bolstering EM local debt for now. DM rate hikes have hit EM hard in the past, but we think they’re in a different spot now thanks to improved external balance sheets. We think that’s why we’re not seeing the EM asset volatility as in the 2013 taper tantrum. The Fed’s plan to taper bond purchases then sparked sharp EM capital outflows and currency depreciation. It’s the opposite now: Capital inflows and stronger currencies are boosting returns in EM local currency bonds.
A brighter EM macro and policy picture may also be underappreciated, in our view. DM central banks inching toward the end of rapid hikes is good for EMs – but a key difference is we think EM peers are closer to rate cuts as inflation falls. EM central banks were well ahead of DM peers in hiking – and some have hiked much more to bring inflation down quickly. Take Brazil: Policy rates have risen to just under 14% from 2% in 2021.
When it comes to EM investing this year, much focus has been on China’s economy losing steam. But outside China, EM equities have staged a stealth rally with double-digit gains across Latin America and other parts of Asia. We see more upside there and more attractive valuations relative to DM economies as the policy picture and EM economic growth prospects improve, even as China’s restart sputters. That’s the first layer of our new playbook in action: Our macro take in the context of what’s in the price.
The second layer of our new playbook is about getting granular. We go beyond broad EM exposures to find the brightest macro backdrops across countries and most attractive valuations under the surface. Within EM local currency bonds, we like Mexico for its quality tilt and Brazil for its exceptional carry from still-high bond yields.
Our playbook also calls for being nimble. EM is not disconnected from global growth, so we are constantly watching for how that may affect the EM backdrop.
We also get granular in sectors and regions and use the third layer of our playbook – harnessing mega forces – to capture returns now and in the future. We see five big structural forces transcending the macro backdrop: digital disruption and artificial intelligence (AI); geopolitical fragmentation; the low-carbon transition; aging populations; and the future of finance. We see abundant EM equity opportunities through these mega forces – what matters is what markets have priced.
The semiconductor industry is powering AI and is a key part of the EM technology sector. A rapidly growing population in India sets the country apart from DMs. India’s system of digital payments also bodes well for the future of finance there, we believe: It could pave the way for a credit boom as banks adapt lending.
We think the low-carbon transition presents an important opportunity for Latin America, especially for countries that hold large reserves of key resources like copper and lithium. The rewiring of supply chains due to global fragmentation could also have significant implications for countries like Mexico that could benefit if U.S. companies bring operations and production closer to home.
Our new playbook leads us to favor EM over DM assets. We see a brighter policy outlook as some EMs stand ready to cut policy rates. We get granular in EM debt across countries and in EM equities by harnessing mega forces.
View the full report from BlackRock’s July 2023 Weekly Market Commentary, “Applying our playbook to EM,” by Wei Li, Global Chief Investment Strategist, BlackRock Investment Institute, Alex Brazier, and Axel Christensen, Chief Investment Strategist for Latin America, BlackRock Investment Institute, and Michel Dilmanian, Investment Strategist, BlackRock Investment Institute
Alex Brazier is Managing Director, Deputy Head of the Blackrock Investment Institute at BlackRock Inc.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2023 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared July 17, 2023, on the BlackRock website. Used with permission.
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