Caution will be needed in emerging markets in 2017, waiting to find the right entry point

2016 has been a better year for emerging market returns after underperforming for many years. However it has been a volatile year and one has had to be an active manger, being selective, tactical and rotating between asset classes and currencies to maximize returns. The main driver of the emerging market recovery this year has been down to liquidity. Markets initially fell sharply in the first six weeks of the year on China RMB weakness, negative interest rates and lower oil prices but recovered sharply when the Fed signaled no rate rises and the dollar was weaker.
Recently Emerging markets have corrected since the Presidential election with most of the years inflows coming out in the following week. This is because initial dollar strength and US bond yields are a strong headwind especially after a solid six months of performance.

The recent US Interest rate rise and Fed guidance on 3 more potential rises in 2017, rather than the 2 expected by the market, is a real negative for Emerging Markets next year.

However, it need not be … particularly if you can be selective and differentiate in equities. The first quarter could give a very good entry point. Firstly it is too early to forecast Fed policy as we don’t know the details of the Trump administration. Secondly Emerging Markets are in much better shape than they were in 2013. GDP growth is picking up slowly, Balance sheets have improved, Debt ex China has dropped and many Central Banks have better management, particularly, Brazil, Indonesia, India and Argentina. However the key is to differentiate between countries and sectors as some countries will be more impacted by rising rates and a stronger US dollar.

The real key in the equity space is that earnings growth forecast are more realistic and actually there is a chance of being over 10pc rather than disappointing in the last few years. Positioning is now very light and most investors are underweight.

Initially into the 1st quarter higher rates will hurt as will the dollar strength but interest rates are going up because of US growth and that is positive. At the same time whereas Emerging market FX weakness is a drag on earnings, stable commodities prices and a higher oil price are a earnings growth supportive.

The unknown risk is obviously the political environment and what could happen on trade. However it is noted that the US senate that controls trade and not the US President. We are tactically cautious on Emerging markets into the 1st quarter but would be looking for a strategic entry point at some point next year. The Japanese market in the short term is likely to continue to perform better than Emerging Markets driven by the weaker yen.

For the year as a whole we are looking for reasonable upside in Emerging markets, both from the extra yield that Emerging Market Sovereign USD bonds give and especially from Emerging Market equities. In regional terms our preference is to overweight Asia, neutral Brazil and underweight EMEA. However the key is to be Active, differentiation at a country and sector level will be key, and timing will be crucial.