Spotting Opportunities and Risks Across the EM Investment Universe
Similar to stargazers, investors can benefit from looking through a variety of lenses to form an overall picture. Three lenses commonly used to evaluate investments are valuations, technical factors, and fundamental characteristics, and the relationship among the three can vary throughout a market cycle.
In emerging markets (EM), valuations – which assess what an asset is worth relative to similar securities, historical norms, and future expectations – look attractive today after the losses across financial markets early this year. EM option-adjusted spreads were recently in the 98th percentile of levels observed over the past 20 years, according to JPMorgan EMBI Global Index data as of 29 July 2022.
Yet EM remains susceptible to technical factors, which include a market’s trading dynamics and shifts in investor sentiment. This year has produced the worst EM fund outflows on record, according to Emerging Portfolio Fund Research, and EM remains vulnerable as the U.S. Federal Reserve and other central banks raise interest rates in an attempt to fight inflation without inducing a recession.
As the outlooks for inflation and monetary policy become clearer, EM could be poised to rally. At that point, fundamentals – which assess the underlying financial picture and creditworthiness of a company or country – can become more important differentiating factors. In EM, those differences can be key for investors, because country-specific risks can balloon more quickly and unexpectedly than risks in other credit-related sectors. Here, we explore some areas of EM that may show signs of heightened risk today.
Locating gravitational distortions
PIMCO’s investment process is founded upon our macroeconomic outlook and our in-house country and credit research. To further guide that process, PIMCO has developed a “black hole risk” framework that aims to identify and avoid extreme, country-specific situations where the first price decline may not signal a buying opportunity but rather a gateway to further declines, creating a gravitational spiral that offers investors no escape.
A careful approach to country and security selection can help anticipate disruptions such as credit-rating downgrades, political turmoil, policy changes, imposition of capital controls, or sovereign debt defaults. Our risk framework looks at factors including inflation, GDP, debt and deficit levels, currency reserves, corporate and banking sector risks, and external financing availability.