Rahman: EM central bankers have been cautious about removing crisis-era stimulus, but they are also concerned about asset-market bubbles resulting from a sharp influx of short-term capital flows. So, they are using a combination of tools. They are relying increasingly on reserve requirement increases and macroprudential measures, e.g., Brazil’s tax on corporate foreign borrowing with less than two years maturity. And in several cases they have allowed their currencies to appreciate, which lowers price pressures from imported goods.
Importantly, central bankers are taking such steps in conjunction with policy rate hikes and efforts for fiscal consolidation. The challenge for EM central bankers is to remain ahead of inflation expectations and retain credibility regarding their inflation targeting objectives. We feel they are well positioned for this.
Q. Certain emerging nations have been reluctant to let their currencies float. How does PIMCO see this
issue playing out, and how are currency values being affected?
Rahman: Fundamentally, we believe the majority of EM currencies remain undervalued from a long-run valuation perspective. This – notwithstanding differences in trade openness, inflation momentum and the composition of capital inflows – underlines the various responses to allowing currency flexibility.
Asian countries, which have so far allowed limited real currency appreciation and are facing growing inflationary pressures, are generally moving to allow faster nominal appreciation. We expect this trend to continue and be facilitated by China’s depegging from the dollar.
Elsewhere in EM there is likely to be continued resistance to further currency appreciation, particularly in some Latin American countries which have experienced rapid real appreciation beyond pre-crisis levels on the back of sharp portfolio inflows.
Q. What’s the takeaway for investors considering emerging markets?
Rahman: We believe emerging markets will increasingly play an important role in global portfolios as investors reorient to our New Normal view of the world. A key part of this process will be a shift from a tactical allocation to EM in global portfolios to EM assets being an integral (and increasing) component of investors’ strategic allocations. Our estimates point to a significant underallocation to EM relative to their global economic and financial importance indicating multiyear structural support for the asset class.
Within this context, bonds denominated in local currencies of EM countries are especially attractive, underpinned by the secular appreciation of EM currencies, opening domestic markets and high yields relative to macroeconomic fundamentals. We also see opportunities in U.S. dollar-denominated debt of emerging market sovereigns and corporates, as the maturation of EM sovereigns continues and select EM corporates may offer yield pickup and diversification benefits vs. advanced economy corporate exposure.
To be sure, investors are likely to see some volatility along the journey to our secular destination of the New Normal. Indeed, investing in foreign securities, including emerging market securities, could involve heightened volatility from factors such as currency fluctuations or political or economic risks. Also, the increase in global investor interest in emerging markets could mean valuations become relatively stretched at times. Overall, however, given their strong economic fundamentals and increasing global role, we believe emerging markets offer a compelling secular story.
Thank you, Lupin.
Sources: World Bank for expansion of global middle class; PIMCO, Bloomberg for inflation figures.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
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