Global market volatility should be positive for stocks in some emerging markets

What does the recent global market volatility mean for emerging markets investors? Here’s an update from Pendal’s Global Emerging Markets Opportunities team

• Key EM factors: Decline in US yields and expectations of Fed rate cut
• We may see monetary stimulus from Asian EM central banks
• Mexico and Brazil set up for fixed-income inflows and significant rate cuts
• Find out about Pendal Global Emerging Markets Opportunities fund

WE’VE seen significant volatility in global financial markets – including emerging markets – in recent weeks.

The main cause was a combination of softer US economic data coinciding with an increase in policy interest rates in Japan.

As a result, we experienced multiple dislocations in fixed interest and currency markets, as “carry trades” were aggressively unwound. Carry trades involve investors borrowing a low-yielding currency to invest in a higher-yielding currency.

This caused a rapid risk-off move across most global financial markets.

In the emerging markets space, market segments with the highest exposure to international investors saw the greatest volatility and weakness.

In EM equities, the pain was concentrated in the information technology (IT) sector, and across Korea and Taiwan. Among currencies, the high-yielding Brazilian Real and Mexican Peso saw the sharpest sell-offs.

What’s next?

The key question now is: what happens next?

We find it hard to be overly positive about the IT sector, despite a reset in valuations from market weakness.

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Pendal Global Emerging Markets Opportunities Fund

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The entire sector has re-rated substantially in recent years, despite essentially soft demand in important end-demand segments such as PCs and mobile phones.

This optimism has been attributed to a potential demand shift from widespread adoption of generative artificial intelligence.

But beyond some key semiconductor names held in our portfolio, we have not seen sufficient evidence of this opportunity.

From a country view, this translates into ongoing caution towards Korean and Taiwanese equities.

Where the opportunities are

In our view, the last six weeks of price moves create opportunity in emerging market interest rates – especially their role as potential drivers of broad domestic demand and local financial markets.

The sell-off prompted repricing of US policy interest rate expectations.

Yields in the middle part of the US Treasuries yield curve have declined by more than 0.5%.

Meanwhile the 12-months-ahead futures-derived expectation for the US Federal Funds policy interest rate are down nearly 1% since May.

In emerging Asia, some economies have failed to fully close the output gap that the Covid slowdowns created.

This has been accompanied by undershoots in inflation and core inflation. But local central banks have been unable to respond with interest rates cuts in the face of stubbornly high US bond yields and interest rates, and a stronger US dollar.

If the Federal Reserve is now to move to reducing policy interest rates, emerging Asian central banks can respond more directly to domestic growth and inflation conditions.

Some Emerging Asian central banks have local issues that may constrain this effect – notably Bank of Korea’s concerns regarding household leverage and the Reserve Bank of India’s worries about growth in unsecured lending.

But we see output gaps, low core inflation and concerns about currency weakness in Indonesia and China – and both of these markets (which are held as overweight positions in our portfolio) could see significant monetary stimulus in the next few quarters.

Mexico and Brazil

Mexico and Brazil also look well placed in the medium term.

Firstly, despite the currency weakness caused by market volatility, the interest rate gaps that drove bond market inflows remain (Brazilian policy interest rates: 10.5%; Japanese policy interest rates were just hiked from 0.1% to 0.25%), and a period of market stability is likely to see a resumption of inflows.

Secondly, we believe the Peso and Real went into the sell-off with some challenges from weaker export revenues, but in no sense overvalued.

Mexico had a trailing current account surplus in the first quarter of 2024, while Brazil’s trailing deficit to June was only 1.4% of GDP – small by historical standards.

Thirdly, real interest rates in both countries remain very high compared to historical levels, with US rates and yields the dominant constraint on cuts.

The faster the US Fed moves to cuts, the faster Banxico and the Brazil Central Bank can follow – which should be highly stimulative for both economies.

It has been a challenging period in global markets, but we believe the fall-out is ultimately positive for emerging equity markets, and particularly positive for the markets we hold as overweight positions in the portfolio.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
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