Low yields “forever” throws spotlight on emerging assets

The Fed’s view that the economic case for a rate rise is strengthening might lead some investors to believe that the nightmare of low growth and low yields is ending.

Their optimism is probably unfounded.

A downbeat update from the Congressional Budget Office (CBO), confirms that recovery in developed markets is weak, and may further convince investors of the case for emerging markets.

The CBO downgraded US potential growth by 10bp from its January projections to 1.9% and also shaved around 40bp off its long-term neutral rate to 3.1% in nominal terms and 1.1% in real terms. The long-term neutral rate is the Fed funds rate that neither stimulates nor restrains economic growth. Any fall in this rate is usually mirrored by a fall in interest rates and in bond yields. From an investor’s standpoint, it feels as if rates are not just lower for longer, but lower “forever”. This long-term scenario is not materially changed by Janet Yellen’s speech at Jackson Hole last week, which has increased expectations of a one-off rise by the Fed this year.

Given the persistently low-yield environment in the developed world, diversification remains key to performance. In geographical terms, our strongest overweight convictions are in emerging markets, with both fixed income and equity markets equally attractive today.

We are positive on emerging market debt issues, both in local and in hard currency terms, as they offer considerable yield pick-up compared to low-yielding sovereign bonds. Since the main developed-market central banks, including the Fed, have adopted a dovish monetary policy bias, there is little funding pressure on emerging economies. In addition, current account balances, an important indicator for investing in emerging markets are improving. The gradual reduction of deflationary pressures in China is encouraging too.

Emerging market equities are our strongest regional conviction. After several years of underperformance, partly due to the collapse in commodity values from mid-2014, equities possess the highest re-rating potential. Valuations relative to developed market equities are still attractive, economic growth is stabilising and the scope for US dollar appreciation is limited. We are also confident that a sharp global macro slowdown can be avoided, given that accommodative central bank intervention is here to stay. Finally, the timing looks good, as investors start to rediscover emerging markets. Investor flows have increased into the region, leading technical indicators to produce a breakout signal for emerging market stocks.

Nadège Dufossé – Head of Asset Allocation – Candriam Investors Group