International Strategy

Timely commentary from Wells Fargo Investment Institute on international topics in the news.

June 23, 2017

Peter Donisanu, Investment Strategy Analyst

No Love for Emerging Europe, Middle East and Africa

  • Financial assets in the emerging market (EM) Europe, Middle East and Africa (EMEA) region have lost favor with some investors over the past few weeks.
  • We believe that commodity-price weakness, political uncertainties, and economic challenges in the region’s major markets (Russia and South Africa) have largely weighed on market-participant sentiment.

What it may mean for investors

  • We maintain our unfavorable rating on EM equities in the EMEA region and advocate regional bond-market exposure through an allocation to a dollar-denominated EM strategy.

Stocks, bonds and currency markets in the EM EMEA region are under pressure as falling commodity prices, rising geopolitical concerns surrounding Russia and ongoing economic dysfunction in South Africa have weighed on market-participant sentiment. Over the past month, the MSCI EM EMEA index has fallen by 3.9 percent, compared with a gain of 0.3 percent for the broader MSCI Emerging Markets index. Bonds in the region have outperformed broader emerging-market indices, yet a recent sovereign ratings downgrade and crude-oil-price decline have called into question the regional bond market’s staying power. We believe that ongoing challenges in the EM EMEA region support our unfavorable rating for its equities and reinforce our view of a diversified bond exposure via allocations to dollar-denominated emerging-market strategies.

Chart 1: Year to Date, EM EMEA Equity Markets Have Underperformed EMEA Bond MarketsChart 1: Year to Date, EM EMEA Equity Markets Have Underperformed EMEA Bond MarketsSources: Wells Fargo Investment Institute, Bloomberg; 6/21/17 Past performance is no guarantee of future results.

Looking Forward

Russia and South Africa are sizable constituents in emerging-market equity and bond indices. As such, we expect market-impacting developments in these countries to likely have a notable impact on broader EM EMEA regional performance. For Russia, a confluence of negative events has recently upended the previously-optimistic outlook for investing in its markets. Market participants had looked on Russian assets favorably as it had appeared that the incoming presidential administration of Donald Trump could potentially take a softer stance on U.S.-Russia relations.

Fast forward eight months, and now some policy-watchers are suggesting that relations between the two countries are at their most tenuous since the end of the Cold War. Heightened U.S. involvement in Syria has recently risked direct confrontation between U.S. and Russian militaries. Expectations for easing of the sanctions against Russia (that have weighed on its economy since they were imposed in 2014) all but evaporated this week as Congress moved to broaden (not loosen) Russian sanctions. Adding insult to injury, Brent crude-oil prices slid to their lowest level in more than 14 months this week given the ongoing market concerns about oversupply in global oil markets.

Earlier this year, South Africa’s financial markets also rallied as external influences, such as stabilizing commodity prices, rising global trade and evidence of a seemingly synchronized recovery among the world’s largest economies, were expected to boost this trade-dependent economy. Yet, a government report on first-quarter gross domestic product (GDP) showed that South Africa’s economy contracted 0.7 percent compared to consensus expectations of a 1.0 percent expansion. As a result, the country’s economy technically entered into a recession following contractions in the fourth and first quarters. Weaker-than-expected economic growth has arguably come as a result of waning domestic business and consumer confidence, given the economic-policy uncertainty surrounding the administration of President Jacob Zuma, particularly as it pertains to central-bank independence.

We believe that Russia’s and South Africa’s financial markets will continue to face a number of headwinds in the coming months. This is particularly notable for investors who have equity exposure to the EM EMEA region, given that Russia and South Africa account for nearly two-thirds of the MSCI EM EMEA equity-market index and one quarter of the Bloomberg EMEA Local Sovereign Bond index. For EM EMEA equity markets, we maintain our unfavorable rating as our quantitative work continues to reflect an environment with stretched valuations (meaning expensive stocks) and a subdued economic backdrop, which could weigh on corporate earnings. Further, we expect market-participant pragmatism surrounding current events to overcome earlier optimism as negative economic and geopolitical conditions continue to weigh on these two key EM EMEA equity markets.

In contrast with the region’s equity markets, Russia’s and South Africa’s bond markets have not been as sensitive to political and economic developments as their equity markets have been. Yields on South African 10-year local currency sovereigns have continued to trend lower, despite political and economic concerns even as Fitch cut the government’s sovereign rating to junk status in April. On Monday, the yield on 10-year Russian local currency sovereigns rose by 25 basis points (0.25 percent) from the level a week earlier, after the news on sanctions broke; yet they have fallen throughout this week. While performance in these countries’ local-currency bond markets has been generally positive, we believe that a key threat to these two bond markets (and, more broadly, to emerging-market bonds) is likely to come from currency risk.

Chart 2: Emerging Market EMEA Region Currencies Have Weakened RecentlyChart 2: Emerging Market EMEA Region Currencies Have Weakened RecentlySources: Wells Fargo Investment Institute, Bloomberg; 6/21/17.1

Emerging-market currencies largely have strengthened versus the U.S. dollar this year, but we expect this trend to slow, and potentially reverse, throughout the second half of the year. A near-term reversal is already underway for the Russian ruble and South African rand—as sentiment in these currency markets has mirrored that of these countries’ equity markets. At a broader level, we continue to expect ongoing policy normalization by the Federal Reserve (Fed) to be dollar-positive in the second half of 2017. The pace and magnitude of the strengthening dollar is likely to be dependent on inflationary pressures (which have eased recently), changes in Fed governance leadership this year, and on the potential for introduction of pro-growth fiscal policies later in 2017.

Bottom Line

We believe that geopolitical risks and economic uncertainty will continue to weigh on market-participant sentiment in the emerging-market Europe, Middle East and Africa region (particularly in Russia and South Africa). This view, combined with stretched valuations and other weak market measures, reinforces our unfavorable equity rating on the EM EMEA region. We nevertheless favor exposure to the EM Asia region, in which economic and market measures remain favorable. We recommend that investors maintain such exposure as part of a diversified allocation to the emerging-market equity class, for which we maintain an evenweight (neutral) tactical recommendation.

As for EM EMEA bonds, we believe that local-currency bond market performance this year is likely to be driven by investors’ search for yield, despite ongoing geopolitical and economic concerns in the region. That said, we believe investors are best served by maintaining a broadly-diversified exposure to emerging-market bonds to assist in reducing region-level market volatility. Further, we believe that there is potential for dollar strength later in the year. For these two key reasons, we recommend that investors maintain a 100 percent dollar-denominated strategy for emerging-market bond exposure.

1 EM EMEA Region – Data reflects weighted changes in the South African rand (53.8%), Russian ruble (25.9%), Polish zloty (10.5%) and Turkish Lira (9.8%) versus the U.S. dollar.
Emerging Markets – Data reflects the MSCI Emerging Markets Currency index.

Risk Factors

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.

Sovereign debt is generally a riskier investment when it comes from a developing country and tends to be a less risky investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk.

Currency hedging is a technique used to seek to reduce the risk arising from the change in price of one currency against another. The use of hedging to manage currency exchange rate movements may not be successful and could produce disproportionate gains or losses in a portfolio and may increase volatility and costs.


An index is unmanaged and not available for direct investment.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

MSCI Emerging Market Europe, Middle East and Africa (EMEA) Index is a free-float weighted equity index. The index was developed with a base value of 100 and a base date of December 31 of 1998.

MSCI Emerging Market Currency Index tracks performance of currencies within the MSCI Emerging Market Currency Index sets the weights of each currency equal to the relevant country weight in the MSCI EM Index.

Bloomberg Emerging Market Local Sovereign Index is a rules-based market-value weighted index engineered to measure the fixed-rate local currency sovereign bonds issued in emerging markets as identified by Bloomberg.

Bloomberg Emerging Market Local Sovereign Europe, Middle East and Africa (EMEA) Index is a rules-based market-value weighted index engineered to measure the fixed-rate local currency sovereign bonds issued in the EMEA region as identified by Bloomberg.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.