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Will EMs sink or swim? Lombard Odier CIO discusses the challenges ahead

Will EMs sink or swim? Lombard Odier CIO discusses the challenges ahead

Emerging markets could face volatility ahead of central bank announcements and suffer from a weak commodity outlook, but they will continue to delivery all the same.

This is according to Stéphane Monier, head of investments at Lombard Odier Private Bank, who has maintained an overweight to emerging market equities and local currency debt.

Although emerging markets were the star performers in the first half of the year and are now delivering roughly twice the growth of developed markets, Monier has pinpointed major challenges to growth to watch for over the coming months.

Veering valuations

Following a sharp fall for EM currencies in recent years, Monier said they are 20% undervalued compared with their fair value on a purchasing-power parity basis. But how long this will continue for remains to be seen.

‘EM local currency debt currently offers spreads of around 400 basis points over US sovereign debt: more than twice the yield differential available 10 years ago.’

Even so, cheap valuations and easy financial conditions are beginning to recede, which could spell trouble for the second half of 2017.

‘EM equities now trade at 13.4 times estimated 2017 earnings – up from 10 times in the early years of the decade – one corollary of money flowing back into EM funds.’

Fed fall-out

Emerging markets could face temporary volatility, with the Lombard Odier PB team predicting balance sheet shrinkage, a further rate hike from the Fed in the US and an announcement on reduced asset purchases from the ECB.

‘To varying degrees, EMs import Fed tightening via their exchange rates, potentially damaging growth.’

Despite the US dollar’s sharp rise in 2016 and the Federal Reserve’s rate hikes, EM equities and bonds have continued to gain ground.

‘Many EMs now have floating exchange rates, preventing the kind of currency/debt crises seen in previous decades.’

Commodity concerns

A weak oil price and commodity outlook may not be a good indicator for oil exporters but Monier points out that many emerging markets in Asia are importers and are set to gain.

‘Commodity price weakness in 2017 has so far failed to dent EM performance. Despite concerns over US shale investment and increasing production in Nigeria and Libya, we believe the Organisation of the Petroleum Exporting Countries (OPEC) will strive to keep a lid on production and support oil prices.’

With this, the private bank’s core scenario sees oil evolving within a $45-60 per barrel range over the next year, which in his view, should not knock the emerging market growth story.

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