"Is now the right time to buy?" This is the question that is - and should be - on the minds of investors after the sharp movements in financial markets that began in May. Virtually no sector of the global fixed income market was immune, and emerging markets (EM) was no exception, experiencing one of its worst periods of performance in the past decade. In the three months ending in July, local currency-denominated EM sovereign bonds fell 10.6%, U.S. dollar-denominated EM sovereign bonds declined 7.8%, and U.S. dollar-denominated EM corporate bonds dropped 5.8%. EM equities also fared poorly, falling 7.8%.
The past would suggest that periods of underperformance in EM ultimately could become buying opportunities. Over the past 10 years, quarters in which total returns were negative were followed by quarters of positive returns more than 70% of the time in local currency- and U.S. dollar-denominated EM bonds. This implies that in
the past a certain amount of mean reversion has been the norm, in which selling during periods of stress overshoots and is followed by a bounce in prices after the stress subsides.
But it is dangerous to rely on simple historical patterns to form an investment thesis in the current environment. The past 10 years have seen an unprecedented decline in global yields. The recent sell-off of course was triggered by concerns that the tapering of large-scale asset purchases by the U.S. Federal Reserve would remove a key source of support for market valuations. Whether or not one believes that the market reaction to prospective tapering is overdone, it is clear that after unprecedented intervention in financial markets, the Fed at some point faces the challenge of unprecedented withdrawal. With all these "unprecedenteds" floating around, backward-looking analysis should be treated with caution.
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