Fundamentals Remain Intact

Volatility Revisits Emerging Markets

We don't see recent market stress from Argentina flowing into other countries, and we still view broad EM equity and debt fundamentals as strong.

In this era of heightened global market volatility, emerging markets (EM) are grabbing headlines. The latest turmoil remains limited to only a few developing countries, but media reports are fanning fears that it could spread to others.

We believe these fears are unfounded, and Client Portfolio Managers Nathan Chaudoin and Joyce Huang explain why investors should look beyond the headlines and focus on still-solid EM fundamentals.

What's causing the recent volatility in EM?

Nathan Chaudoin: Rising U.S. Treasury yields and a stronger U.S. dollar are the primary drivers of the recent sell-off among EM stocks and bonds. Geopolitical influences, such as concerns about a trade war between the U.S. and China and historic election results in Malaysia, also have weighed on investor sentiment.

Although the trade dispute ultimately will have little impact on China's overall economy, it remains a source of volatility that has prompted some investors to cut their positions in China amid rising growth uncertainties. Nevertheless, we continue to have a positive outlook toward China. The nation's economy is showing no sign of an imminent slowdown, with the services component strengthening and the manufacturing sector remaining robust.

Elsewhere, Malaysian voters on May 9 ousted the regime that had ruled the nation for 61 years. The unexpected turnover injected more uncertainty into the financial markets and raised investor concerns about the transfer of power, the stability and effectiveness of Malaysia's new government, and changes to existing policies and contracts. Key risks include a widening of Malaysia's fiscal deficit and cutbacks in China's investments in Malaysia. While these concerns are certainly valid, it is important to remember that Malaysia comprises less than 3 percent of the broad EM equity universe (MSCI EM Index).

Client Portfolio Manager, Global Growth Equity

Nathan Chaudoin

Client Portfolio Manager

Global Growth Equity

Focusing on the U.S. dollar's rally, given that dollar weakness helped drive EM assets higher over the last few years, is the currency's recent resurgence cause for concern?

Chaudoin: The dollar's strength is largely a reflection of the policy divergence among global central banks. While the Federal Reserve continues to tighten, other central banks remain cautious and accommodative. This has contributed to the dollar rally.

Unlike previous periods of U.S. dollar strength, we believe most EM countries are positioned to better withstand the effects. In particular, EM growth is stronger, current account balances in most countries have improved, and EM inflation generally remains close to or below central bank targets. Muted inflation remains key, because in this environment, currency weakness is unlikely to trigger central bank action that would disrupt EM growth.

Argentina seems to be an exception, though, with its currency plunging sharply versus the dollar. What is your assessment there, and does Argentina pose a broader risk to EM debt markets?

Joyce Huang: Investors have grown impatient with the pace of fiscal adjustment in Argentina. The current account deficit has been on a sharp deteriorating trend due to rising imports, and this has amplified the size of external financing needs. In addition, the central bank relaxed its inflation target in December and lowered policy rates, which led to questions about the central bank's commitment to the disinflation process and its independence.

Meanwhile, tighter global monetary conditions, rising U.S. interest rates, and U.S. dollar strength have been pressuring the Argentinian peso. The central bank's initial reaction was suboptimal, burning approximately 12% of currency reserves before hiking its benchmark interest rate to 40%, and announcing a more aggressive primary deficit target this year (2.7% of GDP from 3.2% previously). The government requested assistance from the International Monetary Fund (IMF), but this will be a difficult path to negotiate, as the new government has to balance the economic consequences of not receiving IMF assistance against the political risks of implementing IMF requirements, including budget cuts and austerity measures that may anger voters.

Client Portfolio Manager Global Fixed Income

Joyce Huang

Client Portfolio Manager

Global Fixed Income

Are any other debt markets particularly vulnerable to a strengthening dollar and/or rising U.S. interest rates?

Huang: Any country with a high current account deficit, such as Turkey, is at risk of facing the same troubles as Argentina. A high current account deficit is viewed as negative during times of rising U.S. rates and a strengthening U.S. dollar due to mounting pressure on local currencies and higher borrowing costs for foreign governments. Turkey and Argentina each have deficits of more than 5% of GDP and double-digit inflation, which are notably higher than other EM countries that have been more cautious about current account deficits since the "Taper Tantrum" of 2013. Indonesia, which is also at high risk, recently started hiking interest rates to defend its currency, and other countries in Asia may follow suit.

In addition to the dollar's surge, oil prices have rallied sharply. How do rising oil prices affect your outlook for EM?

Chaudoin: EM equities and currencies tend to fall as oil prices decline and rise as oil prices increase. This is particularly true when global demand is driving oil prices. However, when prices rise more than 45% to 50% year over year on a sustained basis, higher oil prices tend to have a negative influence on EM assets. That's the point at which oil prices become inflationary, triggering faster central bank tightening or weaker balance of payments.

We believe net oil exporters, such as Russia and Saudi Arabia, will be likely winners, while net oil importers, such as South Africa and India, are most vulnerable to higher oil prices.

Developed market growth has recently shown signs of moderating. Does that factor, along with rising inflation in the U.S., cloud your outlook for EM equities?

Chaudoin: Although the pace of expansion appears to be decelerating, data continue to suggest growth remains healthy in most regions of the world. Synchronized and above-trend global GDP growth remains a key fundamental supporting our still-positive outlook for EM equities. In addition, the growth differential between EM and developed markets still favors EM, and it continues to gain momentum. Furthermore, earnings growth forecasts for EM equities remain robust amid reasonable valuation levels.

However, if we are entering a period of structurally lower growth, we anticipate EM equity index returns will likely be subpar, and volatility will be higher. Additionally, the dispersion of returns among EM countries may be high. These factors underscore the importance of remaining selective and opportunistic, thus highlighting the benefits of active management of EM assets.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Portfolio managers are not licensed by the Hong Kong Securities and Futures Commission to perform any regulated function in or from Hong Kong. Furthermore, none of the portfolio managers are located in or operate in or from Hong Kong.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

The information is not intended as a personalized recommendation or fiduciary advice and should not be relied upon for, investment, accounting, legal or tax advice.