Pimco warns over assumptions of EM rebound

As global investors have fled emerging markets, there is an obvious question for investors: is now the time to buy? The US fund house points to the dangers of relying on historical data.
Pimco warns over assumptions of EM rebound

The recent sell-off in both EM equities and debt inevitably brings with it the question: is now the time to buy EM assets?

According to some surveys, sentiment on EM is the most bearish it’s been in over a decade. EM assets saw a sharp correction in May – particularly severe in China – with emerging markets having fallen out of favour with investors recently.

But looking back over the past decade, quarters of negative performance were followed by quarters of positive performance more than 70% of the time for both local currency and US-denominated emerging market bonds, notes US asset manager Pimco in a research note.

Reason might therefore suggest that after experiencing negative returns in May, June and July, EM assets are due for a rebound.

In the three months ending July 31, local currency-denominated EM sovereign bonds fell 10.6%; US dollar-denominated EM sovereign bonds dropped 7.8%; US dollar-denominated EM corporate bonds declined 5.8%; and EM equities fell 7.8%, according to Pimco.

However, Pimco warns that relying on historical patterns to form an investment thesis in the current environment is dangerous.

The firm points out that the past decade has been unique: the decline in global yields is unprecedented, as is the recent sell-off triggered by concerns over the pending tapering of the US Federal Reserve's quantitative easing programme.

Ramin Toloui, Pimco's global co-head of emerging markets, notes: “Whether or not one believes that the market reaction to prospective tapering is overdone, it is clear that after unprecedented intervention in financial markets, the Fed at some point faces the challenge of unprecedented withdrawal. With all of these ‘unprecedenteds’ floating around, backward-looking analysis should be treated with caution.”

Pimco acknowledges arguments for and against buying EM assets now. There is value to be unlocked from the high yields seen on some EM bonds.

Yields of 6.54% on EM local currency government bonds, 5.95% on US dollar-denominated EM corporate bonds and 5.73% US dollar-denominated EM corporate bonds, all as of August 13, offer an appealing alternative to cash for investors in a questionable global environment, Pimco notes.

The US asset manager is expecting an ongoing reallocation into emerging markets by global investors who, at the moment, are severely overweight developed economies.

Yet Pimco notes, too, that this repositioning will cause volatility in EM equities and bonds. And if global economic growth continues to slow, this could be negative for EM currencies, as investors are less likely to invest abroad.

Taking all of this into consideration, Pimco argues that investors with low exposure to EM bonds should view the recent sell-off as an attractive entry point and consider building positions in EM bonds.

Many investors remain underweight EM assets, and bonds in particular. According to data provider EPFR Global, EM bonds represent only 7% of US mutual fund investments, and an even lower proportion of overall US portfolios.

These periods of market weakness provide an opportunity for smaller retail and institutional investors, in particular, to increase their strategic allocations, Pimco argues.

However, keeping one eye on the global economy is key, as this will ultimately impact EM. While there are signs of strength – housing prices and consumer confidence are rising in the US – the overall picture looks tenuous as Europe “remains mired in a very slow growth game”, and Japan’s “outlook remains cloudy by a possible fiscal contraction in 2014 when the hike in the value-added tax is due to be implemented,” Pimco notes.

EM investors should also remember that large emerging markets are growing at sustainably slower rates, Pimco adds. China notably is facing the most significant structural slowdown since the late 1990s.

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