Emerging Markets: Is now the right time?

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After years of difficulties and underperformance, emerging market (EM) assets have the makings of a potential turn-round. Here I explain our strategists’ long-term positive view on EM currencies and bonds, using our investment strategy process focusing on the three aspects of business cycle, asset valuation, and investor sentiment (Cycle, Value and Sentiment) that my colleague James Barber recently wrote about here.

In recent years, EM bonds and currencies have been weighed down by a number of damaging developments
within their borders. These developments include persistent inflation pressure, political turmoil and
lackluster productivity growth. This year, we have seen a clear improvement in the economic fundamentals
of EM countries. For example, Oxford Economics forecasts that emerging market countries’ gross
domestic product (GDP) will grow by 2% more than developed countries in 2016[[Thomson Reuters Datastream, August 11, 2016]] . Russell Investments
thinks that this improvement could set up the currencies and government bonds of EM countries for a potentially
prolonged period of better performance.

We believe that the asset class most likely to benefit from the turnaround in EM economic fortunes is local
currency emerging market debt (EMD).
The latter consists of bonds issued by the governments of EM
economies in their domestic currencies, including the Brazilian real, the Mexican peso, the Russian rouble
and the Turkish lira.

A framework for assessing local currency EMD

Granted, some of the headline news from these countries is still disturbing, not least the recent coup attempt
in Turkey and the spread of the Zika virus in Brazil. To separate the important from the irrelevant
variables, our team of strategists analyze all asset classes through the lens of Russell Investments’ Cycle,
Value and Sentiment (or CVS) framework.

Here is what this approach can tell us about the prospects for local currency EMD right now.

Value: Our valuation measures suggest that local currency EMD as an asset class is attractively priced
compared to history. This is mainly due to the currencies of these countries. We believe that EM currencies
have declined sufficiently to be significantly undervalued. As of the end of June 2016, the inflationadjusted
trade-weighted exchange rates of important EM economies like Mexico and South Africa are
well below 10-year averages[[Thomson Reuters Datastream.]] . Over a 3-5 year horizon, I think EM currencies are more likely to be stable
or stronger against the U.S. dollar.

Cycle: Longer-term structural weaknesses in these economies persist, but recent economic improvements
are encouraging. Leading indicators in EM economies have drifted up in recent months, signaling better
growth dynamics in the second half of 2016. For example, inflation is slowing in countries such as Brazil
and Russia[[The annual inflation rate in Brazil declined from 10.7% in January 2016 to 8.7% in July 2016; in Russia
it dropped from 15.7% in September 2015 to 7.2% in July 2016.]] . This is positive for the currencies and economic growth, allowing central banks to cut interest
rates from a high level. On the negative side, we are wary of the potential risks from a pronounced slowdown
in China on EM assets and any upcoming potential interest rate hikes by the U.S. Federal Reserve
(the Fed).

Sentiment: Momentum is turning positive for the asset class. A commonly used index used to measure the
performance of the asset class is the JP Morgan Emerging Market Government Bond (GBI-EM) Global
Diversified Index. It is up more than 18% year-to-date as of August 16 after having declined precipitously
for the previous 18 months.

Conclusion: Local currency EMD could do well in years to come

Despite potential setbacks noted earlier, our strategists believe the longer-term picture for EM currencies
and local currency debt is positive. Relative to developed market bonds, the potential risk-reward balance
of local currency debt now appears more favorable.
Of course, whether you are an institutional investor or
a private end investor, timing the right entry point into such an asset class is always important and difficult,
often best aided by guidance from an expert.
The main message from our CVS process is that these assets
may be a very sensible part of a multi-asset portfolio.