Emerging market assets may face their worst monthly performance since 2020, with institutions beginning to buy the dip.

Questioning AI · What is the logic behind institutions bottom-fishing emerging market assets?

Influenced by the ongoing Middle East conflict, one of the hottest trades earlier this year—emerging market assets—may soon record their worst monthly performance since 2020. However, as some institutions have already begun bottom-fishing, many market participants believe that emerging market assets still hold investment appeal.

The logic behind the trend

The Middle East conflict that erupted on February 28 ended the previous strong rally in emerging market stocks and local currency bonds. In the first two months of this year, emerging market stocks and local currency bonds each posted their best starts since 2012 and 2017, respectively. But according to media statistics, as of March 27, emerging market equities had fallen about 10%, and the average yield on emerging market local currency bonds had risen to its highest level in nearly two years. The declines were even larger for energy-importing countries, with bond yields in Poland, South Africa, and Thailand rising by 50 to 100 basis points. Some emerging market currencies depreciated by more than 5%. Overall, emerging market assets are likely to record their worst monthly performance since 2020.

On Monday, with international oil prices continuing to surge over 3%, market risk appetite further declined, with the MSCI Emerging Markets Stock Index falling 1.7% and the currency index dropping 0.2%. The conflict also ended a 20-week streak of inflows into emerging market ETFs listed in the U.S., which had previously seen a total inflow of $58.9 billion.

Some investors worry that to counteract inflationary shocks triggered by rising oil prices, emerging market central banks will be forced to hike interest rates. Meanwhile, the strengthening dollar post-conflict could also harm returns on emerging market investments.

Alexandre Tavazzi, Chief Investment Officer and Head of Macro Research at Pictet Wealth Management in Switzerland, told First Financial that first, the Middle East conflict caused the dollar to strengthen, leading to currency depreciation in emerging markets, which also impacted their stocks due to currency effects. Additionally, the market had generally expected emerging market central banks to cut rates, as inflation in these countries had already declined. However, due to the impact of oil prices on inflation after the conflict, rate cuts have been temporarily shelved, affecting recent trends in emerging market assets.

Benoit Anne, Head of Market Insights at PIMCO, said that the recent decline in emerging markets can also be seen as a “victim of its own success,” where rapid asset gains in a particular sector are often followed by external shocks that reverse the trend.

Some institutions have already started bottom-fishing

After the sharp short-term decline in emerging market assets, some institutions have begun bottom-fishing. Investment firms TT International and AllianceBernstein are betting on emerging market bonds, expecting that central banks, including the Federal Reserve, ultimately will not raise interest rates but instead cut them to avoid prolonged Middle East conflicts that could harm economic growth. PIMCO has recently been promoting “contrarian investment opportunities,” making this opposing view a focus of attention.

Earlier, the currency markets almost fully priced in Fed rate hikes, but this has gradually decreased. As of last Friday, market bets on a rate hike this year had fallen to below 50%. JPMorgan strategists wrote in a report that the Fed has shifted toward “leaning toward offsetting recession risks, and if oil shocks intensify, its stance could become more dovish.”

Jean-Charles Sambor, Head of Emerging Market Debt at TT International Asset Management, said, “The market’s risk pricing for emerging market assets is off,” adding, “We have recently started bottom-fishing in emerging market credit and local bonds, including increasing holdings in Polish and Czech local currency bonds, as well as dollar-denominated securities from Venezuela and Lebanon.”

Christian DiClementi, Head of Emerging Market Debt at AllianceBernstein, also said that initially, the Middle East conflict would trigger inflation, but the longer it lasts, the higher the risk that supply shocks will evolve into demand destruction. Therefore, the most affected emerging markets present buying opportunities.

Moreover, improving fundamentals in emerging markets and the need to diversify investments away from U.S. assets are reasons why institutions remain long-term optimistic about emerging market assets. “Fundamentally, fiscal distress and policy credibility shocks are no longer coming from emerging markets. This will be an excellent reason for institutions to continue building long positions in emerging markets,” she said. She prefers to wait until market volatility subsides before making decisions but reaffirmed her belief that emerging market assets will rebound later this year.

Tavazzi told the reporter that the recent strength of the dollar is more a currency issue than an indicator of dollar asset investment value, and dollar assets did not show strong risk resilience during this Middle East conflict. Therefore, the broader trend of diversifying into non-U.S. assets remains unchanged.

Regarding the outlook for emerging market assets, he said that at the beginning of the year, they advised clients to invest in emerging markets—whether stocks, bonds, or currencies. In the long term, “we expect the Middle East situation to improve at some point. Therefore, emerging market assets still have some very interesting features. Central banks in emerging markets may restart rate-cutting cycles. Also, looking at the emerging bond markets, especially investment-grade bonds, these economies’ corporate leverage ratios are generally lower than in the U.S., and spreads are more favorable. So, investment-grade bonds are also attractive. Additionally, tangible assets like key minerals and metals are likely to become more popular, as many emerging economies produce these specific minerals and metals. So, at some point in the future, investing in emerging markets will again become very attractive, and maintaining long positions in emerging markets remains a wise choice.”

He emphasized that China’s market has shown remarkable resilience during this conflict, which is very noteworthy. Meanwhile, investors must distinguish which parts of the market are growing and which are slowing. Fields like technology, renewable energy, and artificial intelligence (AI) are undergoing impressive changes. Chinese AI companies are also being asked to open their models for rapid industrial application, which is a truly shining and continuously growing area worth investing in.

(This article is from First Financial)