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Emerging markets have had a good run. But things may get bumpier

Some investors are getting more selective in bonds, currencies.

Emerging markets have weathered this year’s market volatility just fine so far. But some investors are using this as an opportunity to get a lot more selective, with challenges looming from trade tensions to the winding down of central-bank stimulus.

“Now we can rule out the ‘global synchronised growth’ theme, which dominated early this year,” said Jinha Kim, head of global fixed income in Seoul with Mirae Asset Global Investments Co., one of South Korea’s biggest money managers. The firm has reduced its position in emerging-market currencies and bonds to neutral, and shifted to underweight for Turkey and Mexico specifically, Kim said.

Kim cited trade tensions in the wake of protectionist moves by US President Donald Trump as a concern for emerging-market growth prospects. Nomura Holdings Inc. analysts led by Rob Subbaraman in Singapore listed trade tensions as one of four potential triggers for “a major market repricing of EM risk premia, sparking a painful EM snapback” in a recent research note. And here are the other three:

  • A US bond-market sell-off, which would diminish the incentive of heading to other currencies for yield premiums
  • Unwinding of quantitative easing by developed-nation central banks. The US, euro region, Japan and UK, added together, will start quantitative tightening in the fourth quarter — potentially reversing portfolio flows to riskier assets, Nomura reckons
  • A China growth slowdown, prompted by the leadership’s focus on reducing financial risk and pollution, which would have harder knock-on effects in emerging market thanks to trade and commodity-price links

“It is notoriously difficult to pinpoint the timing of an EM snapback, let alone the trigger,” the Nomura analysts wrote, offering a best-guess of the third quarter of 2018 as being high risk. Chile, Hungary, Poland and Thailand are among the less vulnerable, while Turkey, Hong Kong, Mexico and Malaysia are among the more exposed, they wrote.

Not everyone sees emerging markets as particularly vulnerable. Hideo Shimomura, chief fund manager of Mitsubishi UFJ Kokusai Asset Management in Tokyo, says that decoupling between the developed world’s credit cycle and that of developing nations could help. Rather than emerging nations with solid growth prospects such as in Southeast Asia and eastern Europe, investors may choose to exit developed-world credit markets, he said.

Countries with large current-account deficits — making them reliant on inflows of foreign funds — and those offering little by way of premium may face the biggest tests if global strains develop.

“We are less constructive on select Asian currencies where we are concerned about valuations — such as in Taiwan and Thailand — and where we see less of a rates cushion in terms of spreads to compensate for higher yields,” says Jens Nystedt, a senior portfolio manager in New York at Emso Asset Management, which oversees $6.2 billion. “We continue to see value in Brazilian, Mexican, South African and Colombian local-currency bonds, including often the FX exposure.”

© 2018 Bloomberg

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