All eyes are on the US Federal Reserve's policy and any signals that the end of its quantitative easing policy is near, so ultimately the outlook for inflation should determine investors' cross-asset allocation, according to Pablo Goldberg, global head of emerging markets research at HSBC Securities.
"Muted price pressures should keep the Federal Reserve engaged with overly loose financial conditions and should continue to serve as an excuse for emerging markets policymakers to continue to debase the local carry trades to fight the currency wars," Goldberg wrote in his latest strategy note.
Local currency bonds in emerging markets "continue to be our preferred asset class," but now the HSBC strategists take a more defensive approach by hedging selectively the emerging markets foreign exchange overlay, he said.
Goldberg explained that emerging markets have been affected by the fact that the issue of an exit from the Fed's QE policy is on the table and in this context "the room for positive added returns from the EM FX overlay on local assets has disappeared, if not reversed, and volatility could be on the rise."
He noted that since the non-farm payrolls data for the US for April, which showed a better-than-expected situation for employment, hard currency debt in emerging markets retraced by 1.1%, local bond yields have flattened and foreign exchange has depreciated 1.3%.
"The best-performing EM asset class year-to-date continues to be local currency bonds, which are up 3.6% in local currency terms," said Goldberg, noting that stocks are "at the bottom of the league table," having fallen almost 1% on the year.
"Local currency debt continues to be supported more by a higher carry, strong institutional inflows and benign inflation dynamics," he said.
DEBT AND EQUITIES
Goldberg recommends "compelling local stories" in the asset class, such as longer-duration bonds in Latin America, in particular Mexico, where foreign flows "continue to be strong and reform momentum is maintained" and Colombia, where foreign participation is low.
In Asia, he recommends India, Malaysia and Thailand, which should be favoured by Japanese flows, and in the Middle East he likes Israel, due to its carry.
He recommends that investors add to their emerging markets equities portfolio, as they are becoming cheaper on a relative basis compared to bonds or US stocks.
Forward-looking price-earnings ratios for MSCI EM remain near the same level of the last 16 months and "not too far from post-recovery lows," while for the S&P 500 they are at a four-year high, he said.
Goldberg expects Asian equities to gain between 15% and 20% this year, despite starting the year "rather disappointingly" with growth of 2% year-to-date.
The HSCB strategists are overweight China, Indonesia and Singapore and underweight Taiwan, the Philippines and India.
In Latin America, they retain their "counter-consensus" overweight stance on Brazil; they are also overweight Argentina and Peru and underweight Mexico, Chile and Colombia.
In CEEMEA, their strongest market call is Turkey, because it "offers the best prospects for the inflation-output trade-off in the region."
They are also overweight Egypt, with the case for this market hinging on three factors: valuation, a possible deal with the IMF and other international assistance, and "a cyclical upturn once the political environment becomes clearer."
They are underweight South Africa and Poland, where they believe valuations look expensive and domestic consumption is "among the least dynamic."
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