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Dirk Hofschire: Is the rebound sustainable?

Following the Federal Reserve's public signaling of its intent to taper its quantitative easing program in mid-2013, emerging-market (EM) equity and debt asset classes posted negative returns and trailed most other asset classes during 2013. However, these asset classes have rebounded so far in 2014. EM equity and debt were the top performers in the second quarter (see chart above), and have been at or near the top on a year-to-date basis as well.

The turnaround has been a result of a number of factors, including improved global financial conditions and lower global bond yields, EM election outcomes that have generally been perceived as favorable, and some stabilization in the EM economic outlook.

Developed-market economies continue to exhibit favorable cyclical dynamics relative to emerging-market ones, but these divergences have narrowed in recent months as activity in some EMs has stabilized. One source of this stability is the improvement in the current account balances of many deficit countries—such as India, Turkey, and Indonesia—that suffered from capital outflows during the second half of 2013.

The performance of EM equities started to improve during the second quarter, boosted in part by China's policy easing. Low equity valuations set a low bar for investor sentiment, and EM economic data has recently begun to surpass subdued expectations. With global financial conditions stabilizing and EM countries experiencing smaller financing needs due to lower current account deficits, EM currencies have also stabilized in 2014 and are no longer creating inflationary pressures in their domestic economies through rapid depreciation.

This shift has allowed some countries to moderate their monetary stances after a period of rate hikes, with Turkey cutting its benchmark rate and Brazil and India pausing. Significant policy easing in China has also been a key ingredient in stabilizing the near-term trends for EM economies.

The question now is whether or not the second-quarter rally has staying power, as several emerging markets continue to face late-cycle challenges. Some larger EM economies still have inflation rates above their central bank targets due to persistent inflationary pressures from lagging cyclical productivity and structural bottlenecks. Corporate profitability remains weak, and bank lending and monetary conditions are tighter than they were one year ago.

Although the switch to more EM policy easing measures may be positive for near-term growth, these late-cycle dynamics leave developing economies susceptible to a potential negative shift in sentiment in global financial markets. Nevertheless, over a long-term horizon, we believe EM economies may be the fastest growing during the next 20 years, with EM assets potentially representing considerable growth opportunities as part of a diversified global portfolio.

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Sammy Simnegar: Strength in Southeast Asia, uncertainty in China

In the second quarter of 2014, emerging-market equities posted their biggest quarterly gain since 2012, as declining global interest rates made it cheaper for companies to access capital, and there was a reversion of last year's underperformers. Even with the rally, the weighted P/E for EM stocks remains below its long-term average (see chart below, right).

Stocks in India enjoyed a supportive backdrop tied to optimism about the May election of Prime Minister Narendra Modi. Even though Brazil made little progress in its structural reforms, its stock market outperformed based on hope there will be an administration change following the October election. Russian stocks suffered a broad-based selloff due to the country's controversial annexation of the Crimean peninsula.

China did well late in the quarter as the economy appears to have bottomed, but longer-term concerns remain about the profitability of companies listed on its market. In my view, the best-case scenario for China is to engineer a soft landing with mid-single-digit GDP growth as it tries to restructure to more of a consumption-led economic growth model.

I remain positive on countries in emerging Asia, particularly the Philippines, India and Indonesia. I also favor EM companies with costs in local currencies and profits in U.S. dollars. Weaker local currencies could boost profit margins and exports for these firms, and they could see gains from stronger U.S. sales.

Mexico, for example, could benefit from its proximity to the U.S. The Mexican government is making economic reforms and opening up the domestic energy industry. In addition, Mexican labor rates are now competitive with Chinese rates for goods shipped to the U.S.

From a sector perspective, health care appears to be an important growth sector for emerging markets, as the middle class there becomes more of an economic force to be reckoned with. I also have a favorable outlook on the long-term growth prospects of e-commerce. In my opinion, this is especially relevant for emerging markets, where there is much less brick-and-mortar infrastructure than in developed markets. Once an e-commerce business has the most eyeballs, it has a lot of monetization capability, which can be a great competitive advantage. And because U.S. investors might not be as focused on international options, one may be able to invest in EM e-commerce industry leaders at lower valuations.

Emerging markets are a mixed bag, with needed structural reforms being discussed or implemented in some countries and not in others. At the same time, many good growth stocks are available at reasonable prices. As long as the global economic recovery remains on track, I am optimistic about the prospects of firms that have above-average earnings growth, where we have high conviction in that earnings growth, and that are trading at attractive valuations.

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  • Sammy Simnegar manages Fidelity® International Capital Appreciation Fund (FIVFX) and Fidelity® Emerging Markets Fund (FEMKX).
  • Get the latest global markets news.
  • Find emerging market mutual funds, ETFs, and stocks.

Jonathan Kelly: Positive, but more-muted, expectations

Emerging-market debt (EMD) has offered a significant yield advantage in 2014 compared to other foreign and U.S. fixed-income sectors (see chart below, right). After reaching a high of nearly 6.5% in February, some of that yield advantage eroded, not surprising considering EMD's year-to-date return of 9.1% (as of July 28), as measured by the JPMorgan Emerging Markets Bond Index Global. Still, its current yield of 5.3% remains attractive, especially compared with the 10-year U.S. Treasury, which yields 2.5%. And given the relative underperformance of local-currency EM debt year to date, this market could offer some compelling opportunities.

However, we are somewhat cautious about the remainder of 2014. The EMD market had attractive valuations coming into this year, but it now appears to be more fully valued. That's not to suggest our outlook is for doom and gloom, just that more caution is warranted given the strong market performance we've seen through July.

From a macroeconomic perspective, separation remains among EMD countries, even among nations within the same region. In Latin America, for example, Brazil appears stuck in a stagflationary environment, while Colombia continues to experience relatively strong growth. In China, there is some evidence that government stimulus is having a small positive impact in the near term, but questions still overhang the property sector and portions of the industrial sector there. Elsewhere, growth remains relatively strong in several Sub-Saharan African countries, while the European Central Bank's stimulus efforts have helped reduce volatility in most European bond markets. Overall, though, inconsistency in the growth picture should be supportive of bond markets.

On the other hand, geopolitical issues have had some meaningfully negative affects on certain countries. In light of the ongoing Russia-Ukraine conflict, bonds of both nations have been understandably volatile, and economic activity in both countries continues to suffer. There is a significant interdependence between Russia and Western Europe, so this remains an area of concern. So far, though, the overall impact has been relatively contained. In the Middle East, civil disruptions in Iraq and violence in the Gaza Strip likewise have loomed large in the headlines, but not necessarily in investors' minds. This is testament to the extremely strong market backdrop, but another reason for additional caution looking forward.

It is important to reiterate that we currently reside in an environment where U.S. Treasury movements should continue to have a direct influence on emerging-market debt performance. In fact, if stronger U.S. economic growth leads to higher domestic interest rates, it could push EMD local market interest rates higher still. Conversely, lower interest rates in the U.S. could lead to stable or lower local market interest rates. Either way, we see the current link between EMD and the direction of U.S. economic potential and monetary policy to be especially strong.

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  • Jonathan Kelly manages Fidelity Series Emerging Markets Debt Fund (FEDCX) and co-manages Fidelity Strategic Income Fund (FSICX).
  • Get the latest global markets news.
  • Find emerging market mutual funds, ETFs, and stocks.

Jonathan Kelly: The transformation of emerging-market debt

What a difference a year makes. In July 2013, the 10-year U.S. Treasury yield was at roughly the same level as it is today (approximately 2.6% as of July 28, 2014). But keep in mind that just two months prior, in May 2013, the yield was hovering around 1.6%, before increasing by a full percentage point (100 bps) in about eight weeks, primarily due to the Federal Reserve's announcement that its bond buying program would be curtailed. Bond markets around the world—emerging market debt in particular—sold off quickly in response to this policy change. Investors left EM debt in droves, leading to a 6.6% decline for the asset class in 2013—its first negative calendar year return since 2008.

So far, though, 2014 has been a very different story, particularly for U.S. dollar-denominated EM debt. The JPMorgan Emerging Markets Bond Index Global gained 5.4% in the second quarter— the highest of any debt category (see chart below, right)—and is up 9.1% through the first seven months of the year, as investors return to the fold.

So what's behind this seemingly abrupt transformation of the EM debt market? Several interrelated factors are at play.

The first is the surprising decrease in U.S. interest rates so far this year, due to disappointing growth in the domestic economy. First-quarter gross domestic product (GDP) dropped at an annual rate of -2.1%, largely the reflection of a weather-related slump. Real gross domestic product (GDP) increased 4.0 percent at an annual rate in the second quarter of 2014, according to the advance estimate from the Bureau of Economic Analysis.

All else being equal, long-duration asset classes tend to benefit when interest rates are falling, and U.S.-dollar denominated emerging-market debt is in the long-duration category. So, simply put, EMD has outperformed this year, at least in part, for the exact opposite reason it underperformed last year.

Credit market conditions are another important component of EMD performance. When investors are more willing to assume risk, it provides a more conducive backdrop for EMD. To measure investors' comfort level with risk, one can point to the Chicago Board Options Exchange Market Volatility Index (VIX). The VIX, which is also known as the "fear index," is a regularly cited measure of equity market implied future volatility. The VIX has touched multi-year lows in 2014, implying that market participants expect fewer surprises particularly compared to last year.

This is partly the result of additional communication from the Fed that short-term interest rates will remain low. The benign environment year to date has spurred investors back into a number of risk asset classes (including EMD), which in turn has led to tighter yield spreads. Bond income and spread tightening combined have driven more than 60% of EMD's 9.1% year-to-date total return.

To be sure, the macroeconomic backdrop in emerging markets remains uncertain. For example, economic growth in China has been tepid by historical standards and excesses of the immediate aftermath of the financial crisis remain an overhang. In Latin America, Brazil appears to be experiencing stagflation, Mexico's growth has disappointed in the short term, while Colombia's economic activity remains relatively strong. By contrast, various Eastern European countries are benefitting from both the strength of the German economy and the efforts of the European Central Bank to head off disinflationary pressures.

In spite of this unevenness, there have been signs of improvement (e.g., reduced trade deficits in India and Indonesia) and optimism (e.g., the election of an expectedly more market-friendly prime minister in India). This, combined with the benign backdrop mentioned earlier, has provided support for EMD for the majority of 2014. Significant wild cards, however, are the hostilities between Russia and Ukraine, and the unfolding developments in several Middle East hot spots.

In sum, the seven months ending July 2014 and July 2013 have been the tale of two different markets. Undoubtedly, economic factors outside of emerging markets have been significant drivers of EMD performance. In particular, the path of U.S. interest rates and its subsequent affect on international capital flows has dominated. It is our expectation that this will continue to be the case for the foreseeable future.

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  • Jonathan Kelly manages Fidelity Series Emerging Markets Debt Fund (FEDCX) and co-manages Fidelity Strategic Income Fund (FSICX).
  • Get the latest global markets news.
  • Find emerging market mutual funds, ETFs, and stocks.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Examples provided are for illustrative purposes only and are not intended to be reflective of results you can expect to achieve.
Past performance is no guarantee of future results.
Neither asset allocation nor diversification ensures a profit or guarantees against a loss.
Information presented is for informational purposes only and is not intended as investment advice or an offer of any particular security. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for investments that focus on a single country or region.
In general the bond market is volatile, and fixed-income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed-income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. High-yield/noninvestment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
1. For Government Debt, emerging markets are represented by JPMorgan Emerging Markets Bond Index (EMBI) Global; U.S. debt by Barclays U.S. Aggregate Bond Index; and developed markets by Citigroup Non-U.S. G-7 Index. For Equity, emerging markets are represented by MSCI® Emerging Markets (EM) Index; U.S. stocks by Standard & Poor’s 500 Index; and developed markets by MSCI® Europe, Australasia, Far East (EAFE) Index. The index performance includes the reinvestment of dividends and interest income. Securities indices are not subject to fees and expenses typically associated with managed accounts or investment funds.
Index definitions
JPM® EMBI Global Index, and its country sub-indices, tracks total returns for traded external debt instruments issued by emerging-market sovereign and quasi-sovereign entities.
Barclays U.S. Aggregate Bond Index is an unmanaged, market valueweighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgagebacked securities with maturities of at least one year.
Citigroup Non-USD Group-of-Seven (G7) Index is designed to measure the unhedged performance of the government bond markets of the G7 excluding the U.S., which are Japan, Germany, France, United Kingdom, Italy, and Canada. Issues included in the index have fixed-rate coupons and maturities of one year or more.
MSCI® Emerging Markets (EM) Index is an unmanaged market capitalization-weighted index of over 850 stocks traded in 21 world markets.
Standard & Poor’s 500 Index (S&P 500®) is an unmanaged market capitalization-weighted index of 500 widely held U.S. stocks and includes reinvestment of dividends.
MSCI Europe, Australasia, Far East (EAFE) Index is an unmanaged market capitalization-weighted index designed to represent the performance of developed stock markets outside the U.S. and Canada.
Barclays ABS Index is a market value-weighted index that covers fixedrate asset-backed securities with average lives greater than or equal to one year and that are part of a public deal; the index covers the following collateral types: credit cards, autos, home equity loans, stranded-cost utility (rate-reduction bonds), and manufactured housing.
Barclays U.S. Agency Bond Index is a market value-weighted index of U.S. agency government and investment-grade corporate fixed-rate debt issues.
Barclays CMBS Index is designed to mirror commercial mortgage-backed securities of investment-grade quality (Baa3/BBB-/BBB- or above) using Moody’s, S&P, and Fitch, respectively, with maturities of at least one year. Barclays U.S. Credit Bond Index is a market value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. BofA Merrill Lynch U.S. High Yield Master II Index tracks the performance of below-investment-grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P. Standard & Poor’s/Loan Syndications and Trading Association (S&P/ LSTA) Leveraged Performing Loan Index is a market value-weighted index designed to represent the performance of U.S. dollar-denominated, institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments.
Barclays Long U.S. Government Credit Index includes all publicly issued U.S. government and corporate securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
Barclays U.S. MBS Index is a market value-weighted index of fixed-rate securities that represent interests in pools of mortgage loans, including balloon mortgages, with original terms of 15 and 30 years that are issued by the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corp. (FHLMC). Barclays Global Treasury Index tracks fixedrate local currency government debt of investment-grade countries in developed and EM markets.
Barclays Municipal Bond Index is a market value-weighted index of investment-grade municipal bonds with maturities of one year or more. Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index (Series-L) is a market value-weighted index that measures the performance of inflation-protected securities issued by the U.S. Treasury.
Barclays U.S. Treasury Bond Index is a market value-weighted index of public obligations of the U.S. Treasury with maturities of one year or more.
Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.
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