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Goldilocks year awaits emerging market assets

The sell-off by FPIs was triggered after Chinese telecom giant Huawei’s CFO Meng Wanzhou. Photo: iStockPremium
The sell-off by FPIs was triggered after Chinese telecom giant Huawei’s CFO Meng Wanzhou. Photo: iStock

  • UBS Group AG says emerging-market assets may benefit from the prospect of 'near-complete normalization' in global economic mobility by the end of next year
  • Goldman Sachs Group Inc and JPMorgan Chase have made bullish calls on the asset class in recent weeks.

Emerging-market investors seem to have everything going for them right now, with the November rally offering a hint of what 2021 may have in store.

A plethora of tailwinds from accommodative central banks to an impending change of U.S. president and Covid-19 vaccine progress has put the assets of developing nations on course for some impressive milestones. Bonds have wiped out their year-to-date losses, while MSCI Inc.’s currency index is poised for the best month since January 2019 as well as a second successive annual gain. The MSCI stocks gauge is on track for its best month since March 2016.

Underpinning the recovery is a resurgence in foreign-investor interest. Fourth-quarter portfolio inflows to emerging markets are poised to hit the highest in eight years, data from the Institute of International Finance show. Yet, for all the euphoria, foreign positioning in bonds and equities for developing nations excluding China remains light, and Deutsche Bank AG’s Sameer Goel, says the rally is far from over.

“It’s Goldilocks for emerging markets’ under-invested assets as we go into 2021," said Goel, the bank’s head of emerging markets macro research in Singapore. They “have considerable cyclical catch-up potential."

Deutsche Bank isn’t alone in seeing further gains. Goldman Sachs Group Inc. and JPMorgan Chase & Co. have made bullish calls on the asset class in recent weeks. UBS Group AG said last week emerging-market assets may benefit from the prospect of “near-complete normalization" in global economic mobility by the end of next year.

Mobility is key to the recovery, which is why the possibility of a spike in Covid cases remains a risk as average temperatures drop in many of the developed economies and people socialize over end-of-year holidays. Moves by some central banks including those in Taiwan, South Korea and Thailand to become more assertive in stemming currency gains might also limit gains. The behavior of China’s central bank will also be watched for any signs of resistance to the yuan’s strength.

Below are three reasons to be optimistic about the outlook for emerging currencies in 2021 and key events and data to watch out for in the coming week:

Attractive Valuation

Exchange rates in developing economies are still modestly undervalued, with an average Z-score of minus 0.4 using a simple metric of the current REER versus the five-year average. Countries such as Brazil, Turkey, Russia, Hungary and Malaysia have even lower scores, with readings of minus 1.4 or below.

History suggests that there’s scope for improvement. The average valuation Z-score hit positive 0.9 in April 2010 following the Global Financial Crisis in 2008. It also reached plus 0.7 in April 2013 following the implementation of the third round of quantitative easing by the Federal Reserve. Conditions in both periods were similar to those prevailing this year, with historically low U.S. real rates and improving global manufacturing activity.

Real Yield Advantage

An abundance of caution from the Fed -- which under average inflation targeting, has pledged to allow inflation to run at above 2% -- implies that real yields will fall further.

With the stock of the world’s negative-yielding debt exceeding $17 trillion, the hunt for yield favors emerging markets. Juxtaposed against already low U.S. real yields, the 10-year real yields of developing economies -- based on Bloomberg consensus economists’ forecasts –- enjoy a Z-score of positive 0.8 versus the three-year average. The highest scores are for China and South Africa, which both have plus 2.0 readings.

Investor Demand

Trailing 12-month foreign flows into emerging-market bonds have an average Z-score of negative 0.7 versus the five-year average. For equities, the figure stands at negative 1.3. Considering the light positioning in the debt universe, Indonesia’s rupiah and the Mexican peso are well placed to benefit, while currencies of South Korea, Taiwan, Thailand, Malaysia and Turkey stand to win based on data for stocks.

India Decides

  • The Reserve Bank of India is expected to leave its key rate unchanged on Friday as inflation has been running above target for seven consecutive months
  • The RBI may also raise its near-term inflation forecast given the upside surprise since its October review, according to Bloomberg Economics
  • Governor Shaktikanta Das also said last week that the economic recovery had been more rapid than expected, and accordingly, the RBI is expected to raise its GDP forecast for fiscal 2021
  • The RBI has cut interest rates by “a great deal" and more policy space can be created when inflation eases, its executive director and interest rate-panel member Mridul Saggar said

(Simon Flint is an emerging-market strategist at Bloomberg News. The observations he makes are his own and not intended as investment advice.)

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