The latest political developments in Brazil have brought new rounds of volatility, with Brazilian assets recording severe losses after the release of bribery allegations involving President Michel Temer. Brazilian equities, currency and local 10-year bonds all sold off between 7% and 9% the day after the news release. Do these events mark the end of the outperformance in emerging asset classes? We don’t think so.

The optimism surrounding Brazil over the past year was, to some degree, driven by expectations of steady progress on the reform agenda and its implications for fiscal sustainability and business confidence. The current political setback will most likely delay such progress, which justifies the repricing we have seen of a “risk premium” in Brazilian assets.

However, as explained by Hemant Baijal, co-head of our Global Debt Team, these events are unlikely to completely derail the reform agenda given the general acceptance of the need for such reforms. Moreover, Brazil’s outperformance has also been the result of a remarkable improvement in macro fundamentals, as illustrated by a recovering business cycle, a shrinking current account deficit from 4.5% to 1% of GDP, and rapidly declining inflation from 10% to 4%. In other words, compared to the political turmoil of 2015, Brazil’s economy and financial markets are in a much better position to cope with political uncertainty.

What about the broader emerging market universe?

In our multi-asset portfolios we have been overweight emerging markets for the past 12 months, starting with equities and currencies, and adding local debt last October. Therefore, from a portfolio standpoint, the important question is whether volatility in Brazil can create financial contagion in other emerging markets. At this stage, we don’t believe that is the case. Emerging markets are currently supported by favorable fundamentals in terms of both local and global growth dynamics. Our leading economic indicators suggest that all major emerging market economies are in a “recovery” phase of the business cycle, a very constructive regime for risky assets (see Exhibit 1).

Exhibit 1: Broad-Based Improvement in Macro Conditions -- OppenheimerFunds

Emerging market equities are also supported by cheap valuations relative to developed markets (see Exhibit 2), which we believe should provide additional cushion in terms of downside risk, and resilience to idiosyncratic volatility shocks.

Exhibit 2: EM Valuations Are Attractive Relative to DM -- OppenheimerFunds

Finally, our currency valuation framework indicates that high-yielding emerging currencies are undervalued relative to other global currencies, increasing the attractiveness of local currency debt in terms of both income and total return potential (see Exhibit 3).

Exhibit 3: Currencies: Attractive Valuations in High-Yielding EM FX -- OppenheimerFunds

Overall, we believe emerging market fundamentals and valuations are still very attractive, especially relative to developed markets, and we maintain an overweight exposure across equities, local debt and currencies. We will continue to monitor the evolution of our cyclical indicators to gauge whether the current recovery will be impacted by rising volatility and policy uncertainty, and stand ready to adjust our exposures accordingly.

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