EMD got off to a rocky start in 2017. Investors worried that rising US interest rates and a stronger dollar would draw money out of EMD and put pressure on EM government and corporate balance sheets. US President Donald Trump’s antitrade platform and pledges to rip up trade pacts didn’t help sentiment.

But investors who stayed the course did well. Major indices for EM government and corporate bonds—both US-dollar and local-currency denominated—returned between 8% and 15%.

Why has the EMD sector been so resilient? Part of the answer has to do with the health of the global economy. After nearly a decade of subpar growth, developed-market countries are finally starting to gain traction. This is good news for the developing world, because stronger growth in the US and other advanced economies tends to boost economic activity elsewhere.

Emerging economies may not soon regain the breakneck pace of growth that many enjoyed a decade ago. But after several challenging years, many key economies moved back into expansion mode in 2017, and we expect growth in most to accelerate.

Stronger fundamentals should provide EMD with a cushion that it did not have just a few years ago.

 

In 2018, though, investors will have to exercise caution. EM fundamentals remain strong and EMD valuations, broadly attractive. But macroeconomic and geopolitical risks abound, and the global environment has become less certain. The Federal Reserve could disrupt markets by tightening US monetary policy more aggressively than expected. China’s economy could slow further, putting pressure on commodity prices.

These risks and others are difficult to forecast. But any one of them would lead to elevated market volatility and have implications for a wide array of assets, EMD included. That’s why we think it’s essential to stay active and take a highly selective and tactical approach in order to build portfolios that can deliver long-term results.

How Emerging Markets Built Up Shock Resistance

The good news is that critical reforms and stronger economic fundamentals have reduced many developing countries’ vulnerability to external shocks and sudden portfolio outflows. Inflation is broadly under control, current account deficits have declined, and governments are in many cases embracing fiscally responsible policies and reforms and trying to crack down on corruption.

These developments should provide EMD with a cushion that it did not have just a few years ago. In other words, the sector should be more resilient to sudden shocks, what investors refer to broadly as “risk-off” events.

Even so, investors should be selective when it comes to their EM exposure. A one-size-fits-all approach is rarely a good one in any sector. But it’s never advisable when it comes to emerging markets. Country and sector selection matter, because political and economic risk varies across the developing world. We think a tactical approach to EMD will be critically important in 2018.