However, EM bonds should also be able to benefit from the improving growth prospects. After all, the pick-up in domestic demand growth is positive for fiscal accounts, while the strength in global trade should help to prevent a harmful widening of external deficits. It remains important to stress that despite the better growth picture, inflation in the emerging world is still low, at levels below 3 per cent on average.
The steady capital inflows of the past years have led to a sharp appreciation of exchange rates, so much that, by now, in real effective terms, EM exchange rates have recovered half of the big 2013-2015 decline. The strengthening exchange rates in combination with still-below-potential economic growth rates have kept inflation rates low, and have enabled and continue to enable EM central banks to cut interest rates. The combination of improving growth prospects with declining interest rates is particularly beneficial for local currency debt.
The main risks to all EM asset categories are still a shift in market expectations about the speed of DM monetary policy normalisation, and a sudden flare-up of China financial system concerns. Both risks need to be monitored closely. For now, it looks like both the Federal Reserve and ECB will remain very cautious. Recent growth and inflation data do not suggest that an acceleration in policy tightening is near.
With the euro on a clear strengthening path, the possibility of no moves by the ECB well into next year has even increased. And where China is concerned, the recent growth and capital flow data suggest that the authorities have been successful in regaining the minimum of control over the economy they need to prevent volatility in growth and large swings in investor confidence.
The verdict is still out whether China can reduce its leverage growth and high dependence on credit. And whether the authorities can avoid financial system stress as the pace of economic growth gradually comes down to more sustainable levels remains a big question. But one cannot ignore that the recent policy focus on deleveraging and tightening regulation on the opaque and aggressive risk-seeking shadow banking sector is the right one.
Therefore even in China, the principal cause of the painful 2010-1015 EM correction, change is positive now. This has already explained part of the EM resilience since early 2016, but should continue to sustain investor risk appetite to EM assets for a bit longer.
Maarten-Jan Bakkum is senior emerging markets strategist at NN Investment Partners
