This week's chart shows why we are in a sweet spot for emerging market (EM) assets. Three key headwinds for EM assets have abated lately, with a weakening U.S. dollar, a rebound in commodity prices and a recovering Chinese economy.
The Federal Reserve (Fed) has signaled it is set to keep rates on hold for now. This has lowered the near-term risk of EM capital outflows, weakened the U.S. dollar and boosted oversold EM currencies. Also supporting EMs are firming oil prices, fading global recession fears and signs that China's economy may enjoy a cyclical rebound.
This "sweet" economic backdrop helps explain an EM rebound, evident in EM-related exchange traded products (ETPs) attracting nearly $16 billion this year, according to BlackRock research. EM ETPs have recouped 75 percent of 2015 outflows, the "short EM" trade is much less crowded than it was at the start of the year, and EM valuations are no longer unambiguously cheap, our research suggests.
Can the sweet spot continue?
Fed tightening, a Chinese yuan devaluation or economic slowdown, and a renewed slump in oil prices are all risks to the EM story. We see the Fed remaining dovish through mid-year. Yet, risks could return in the second half as U.S. rates increase and China's credit-fueled growth improvement slows.
Evidence of structural reforms addressing excess debt, industrial overcapacity and low corporate profitability is needed, particularly in China, to spark a sustainable EM bull market. Policies currently supporting Chinese growth are actually increasing structural imbalances.
However, while we are in the sweet spot, we do see selected opportunities among EM assets that investors may want to consider, including in EM local currency debt and certain equity markets. Read my full weekly commentary for more details on these opportunities.
This post originally appeared on the BlackRock Blog.