As we noted in our 2018 outlook, emerging markets have cleaned up their act in recent years. They have done this by reducing current account deficits, embracing more responsible fiscal and monetary policies and bringing inflation broadly under control—even as it starts to rise in developed markets.

At the same time, we warned investors to be prepared for volatility, pointing out that EMD’s biggest challenge in 2018 would likely come from monetary policy changes in developed markets and a faster-than-expected rise in US interest rates.

It didn’t take long for volatility to flare up. US Treasury yields began drifting higher in January and the 10-year yield touched 3.11% by mid-May, some 70 basis points above where it began the year. That caused the US dollar to rally against emerging-market currencies and provoked a broad sell-off in EMD assets—dollar-denominated bonds as well as local debt and currencies.

Indiscriminate Selling Creates Opportunities

Such broad moves across EMD can obscure the differences between countries, companies and individual securities. We still think that many EM countries are much better positioned today to withstand sudden outflows.

That’s not to say there aren’t risks on the horizon or that investors should settle for passive exposure to the entire EMD universe. Economic and political risk varies, so country and sector selection still matter. That’s why reducing EM currency risk and overall beta—or market exposure—and taking a more tactical approach that focuses on attractive opportunities in specific countries and companies makes sense.

The broad-based decline in prices creates an opportunity to add exposure to countries and companies with strong fundamentals that have been unfairly punished.

 

But the way we see it, the broad-based decline in prices creates an opportunity to add exposure to countries and companies with strong fundamentals that have been unfairly punished.

Rising yields and dollar strength are headwinds. But they’re not necessarily game changers. In fact, currency moves may not matter as much today for EM countries and companies as they once did. For example, many countries have reduced their current account deficits in recent years. That makes them less dependent on capricious portfolio inflows. At the same time, foreign direct investment—a more stable source of funding because it tends to be long-term in nature—has increased.

EM companies are less exposed to changes in the dollar than investors may realize, too. For example, companies with export revenues dominated in dollars have a natural hedge against their dollar liabilities. For these types of firms, a rising dollar is good news because it boosts margins, which leads to higher cash flow and creditworthiness.

EM corporates with investment-grade ratings have also become much less volatile investments. In fact, over the last three years, high-grade EM corporates have been less volatile than their US counterparts (Display). This is partly because the buyer base has improved: these assets tend to attract large institutional investors with longer investment horizons.

As always, there are risks that investors will have to monitor as we move into the second half of the year. These include ongoing trade tensions, slower growth in China and political risk—in emerging and developed countries alike.

That’s why it’s important to be selective. 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.