Why emerging markets will keep outpacing developed world

The IMF's World Economic Outlook confirmed that 2016 will see strong pick-up in emerging markets' (EM) growth premium versus developed markets (DM).

It's our view that the headwinds of recent years were temporary and their effects cyclical, and that going forward the EM growth premium will likely be sustained.

The EM growth premium

One of the four pillars supporting a bullish view of EM in 2016 is the rising EM growth premium - that is, EM's excess growth relative to DM.

The rise in the EM growth premium was confirmed in the latest update of the International Monetary Fund's (IMF's) World Economic Outlook, published last week.

The IMF revised the EM growth premium up by 0.3% relative to its prior estimate from July of this year. The upgrade was due to a combination of higher expected growth for EM countries and outright lower growth for DMs.

Specifically, the IMF now expects EM growth in 2016 to average 4.2%, up from 4.1% and sees EM growth rising to 4.6% in 2017. The IMF expects DM growth of 1.6% this year, down from 1.8% in its July outlook.

Within DMs, US growth was revised sharply lower from 2.2 to 1.6% for 2016, while UK growth was also revised lower following the potentially economically harmful Brexit decision.

The inflection point in the global growth story is now quite clear. EM's growth premium is likely to continue to gently rise over the next few years.

This matters to investment opportunities, because there is a strong positive correlation between EM's growth premium, EM currencies and ultimately investment returns.

EM's growth premium declined significantly over the last few years due to the headwinds produced by the taper tantrum, the US dollar rally, the fall in commodity prices and the start of the Fed hiking cycle.

EM survived these headwinds with remarkably low default rates and very few balance of payments crises, testifying to the underlying economic resilience of EM economies.

Indeed, it is noteworthy that the EM growth premium never even came close to turning negative during these testing times.

Why is the growth premium now picking up?

The headwinds on EM growth in recent years were temporary and their effects mainly cyclical.

The tighter financial conditions faced by EM countries were caused in the main by capital flight triggered by a giant portfolio shift back to DMs, as investors responded to asset price movements generated by the quantitative easing (QE) programmes of the central banks of the US, UK, the EU and Japan.

EM countries also had to adjust to large currency movements as the dollar surged, shifting resources across sectors - a process that renders those resources temporarily unemployed.

However, these changes have made EM countries far more competitive, because most maintained strict inflation and fiscal discipline during the downturn.

This is why the ongoing cyclical upswing is now led by strong improvements in EM's external balances, which in turn is pushing up both foreign currency reserves and growth via higher net exports.

The EM growth premium is likely to be sustained

EM real effective exchange rates are back to 2003 levels, i.e. long before the subprime crisis and the EM local currency bond rally of the mid-2000s. EM currencies have rallied just 5% this year following a decline of 40% since 2010, in some cases even more.

Bond yields are also much higher than before, particularly relative to US yields, while EM equity valuations are significantly below historical valuations.

EM central banks have room to cut rates, economies have room to grow and it will be a long time before currency appreciation becomes a major constraint to expansion.

The case for EM also rests on three other pillars. Firstly, valuations are good. The attraction of EM fixed income is not just that real yields have risen about 3% since 2013, but also that DM yields are clearly completely distorted (due to QE and misguided regulation).

EM equities recently became more tech-heavy than the S&P 500 Index, yet they still trade below historical valuations. These valuations simply make no sense.

Secondly, the outlook for EM currencies has improved. EM foreign exchange has outperformed the US dollar this year as more and more investors - and US policy makers - realise that the US economy cannot stomach much more dollar appreciation.

Investors like to have money invested in currencies that go up, so as capital flows back, EM financial conditions will ease and growth will pick up further in an exact reversal of the financial tightening of the last few years.

Thirdly, positioning is supportive. Most institutional investors reduced their exposure to EM fixed income - or simply did not add to EM as their AUM went up - in the period since 2013.

So far, about $50 billion (£41 billion) has flowed back to EM (bonds and equities combined), mainly in retail investments and exchange traded funds, but this is an almost insignificant amount, given that the EM fixed income asset class alone is (valued at) $18.5 trillion.

More importantly, institutional flows have barely begun and will probably not take off in earnest until early next year, given the typical lag between performance and allocations.

Currently, positioning is therefore very light, which means that market risks are asymmetric - few sellers during bouts of risk aversion and potentially many inflows in response to better sentiment.

Jan Dehn is head of research at Ashmore.

This article was originally published by our sister magazine Money Observer here

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.