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In developed markets, the painful process of deleveraging continues. Growth rates will be anaemic, at best sub-trend in the US and Japan and likely to include bouts of weakness in Europe.

Emerging market economies will not be immune from the growth slowdown in developed markets, yet growth will still significantly outperform developed markets. We expect a deceleration of growth to a slightly below-trend rate in the year, with a growth rate of 4.6% over a year ago in 2012 for EM economies (relative to 5.6% in 2011), a mild recession in Europe and 1.8% growth in the US.

Lower interest rates

EM also have the ability to stimulate their economies through both monetary and fiscal policies, should this be necessary. Headline inflation rates peaked in 2011 and will fall in the first half of the year, allowing central banks to cut interest rates (for example, in Brazil, Chile, Mexico, Peru, Indonesia, Israel and Poland).

Outside Eastern Europe we expect further ratings upgrades for emerging market countries as stronger economic fundamentals are recognised by the rating agencies (for example, China, Russia, Turkey, Peru and Uruguay).

It is likely that the first quarter of 2012 will remain challenging as the European situation continues to govern risk appetite. However, firmer policies and further global policy stimulus will result in a better risk environment for the remainder of the year.

Currently, our valuation metrics indicate that all EM debt sectors are cheap and priced for a weak growth backdrop, but not for a depression/ dislocated market.

Risks for this year include further disruption from the unresolved European situation, deterioration in developed market growth expectations, and geopolitical tension (for example in the Middle East and North Korea). Political risk will be present through the year in both developed and EM, with elections being held in countries representing close to 50% of the world’s GDP in total (for example, the US, France, Russia, South Korea, Mexico and Venezuela).

Lower liquidity

Finally, liquidity should be highlighted as a risk. Pressure from policymakers and regulators is resulting in a withdrawal of liquidity in the financial markets as banks reduce their balance sheets and their market-making activities. This is affecting the broad financial market, and investors will need to re-price securities to include an appropriate liquidity premium.

The bullish strategic investment case for EM debt remains intact, supported by stronger balance sheet and growth prospects (resulting in a better capacity to pay back debt than in developed markets).

The key headwinds of 2011 - central bank rate rises to contain inflation and a sharp global growth revision - are now priced or overpriced into valuations. The current cheap valuations bode well for EM debt and should attract investors in search of yield and solid diversification.
The asset class is likely to remain volatile, however, driven by continued deleveraging, fiscal austerity and monetary stimulus.

We will start 2012 with a defensive stance in our strategy and move to a more cyclical positioning once the euro crisis has peaked and investors gain comfort that China is heading for a soft landing.