Look to EMD for yield and return
Emerging markets offer strong income and total return opportunities, increasingly difficult to find in developed markets.
Emerging markets (EM) and emerging market debt (EMD) in particular should be of far greater interest to investors. Not only because many emerging markets have had strong economic performance based on good economic policy decision making, but because – and this is intriguing – most institutional portfolios are wildly underweight EMs.
Investors have come to appreciate that EMs represent the bulk of the world’s economy and its population but more importantly, they account for 75% of the world’s growth and 50% of its savings. Why is then that one struggles to reach a neutral EM exposure of around 30% of a fixed income portfolio?
Emerging markets make up between 40%-60% of the world’s economy, depending on how you measure, 60% of the world’s population and their economies are on average growing at twice the rate of developed countries.
EMs will grow at around 4.2% this year and expectations are that they will achieve 4.5% next year. These figures compare very favourably with the sub 2% expected in most developed economies.
Yet factors like domestic bias and a preconception that emerging markets must be high risk means that most institutional portfolios do not even have a neutral exposure to emerging markets, let alone a more meaningful exposure. From a structural, value and asset allocation perspective, this makes no sense at all.
HISTORY OF EMS – A TALE OF CRISIS AND RESPONSE
The 1997 Asian financial crisis and the 1998 Russian financial crisis were devastating for EMs. The Russian stock, bond and currency markets collapsed in 1998 as the combination of a fixed exchange rate, excessive short-term debt and reliance on foreign investors left the Russian government little choice but to float the exchange rate and devalue the rouble – defaulting subsequently on its domestic and foreign debt obligations.
The so-called ‘Asian financial crisis’ followed a similar path: a series of currency devaluations which began in Thailand in 1997 and spread through other Asian markets, caused sharp market declines and a profound confidence crisis from non-resident investors, who had so far been instrumental in financing the continent’s economic growth.
This phase of EM crisis finally came to an end with the 2001 Argentina debt default, the largest of its kind back then.
It’s important to understand these crises, because they set the scene for widespread implementation of comprehensive economic reforms in emerging markets throughout the 2000s which served to build up economic resilience ahead of the Global Financial Crisis (GFC) in 2008. In the early 2000s, EMs followed a common policy framework, consisting of a combination of fiscal rigour, monetary reforms involving inflation targeting and floating currencies, a subset of the so called ‘Washington consensus’. These drastic reforms underpinned the development of local government debt markets as credible alternative to external financing and – as government retrenched from crowding out the international capital markets – local corporates finally gained access to long-term USD funding.
As a result, many emerging markets came out structurally stronger than their developed market counterparts post GFC, in stark contrast to previous crises where emerging markets were hit disproportionately hard. Many EMs were able to run counter-cyclical fiscal expansion to kick start growth out of the post-crisis slump, thanks to their growing foreign exchange (FX) reserves and the good state of their budget and balance of payments.
The new found economic maturity of EMs became obvious in the first part of the last decade, when the combination of slumping commodity prices, slowing global trade and an end to monetary easing in the US (the 2013 ‘taper tantrum’) should have created a shock similar to 1998 or 2008. Yet despite regional fragilities, all but a few countries – such as Ukraine – recovered eventually, without any debt default or banking crisis.
This period of catching-up with industrialised nations was followed by an ever-growing diversification in the EM development models. Countries traditionally focused on export of commodities – in Latin America for example – adjusted to export manufactured products and services. And countries focused on exporting manufactured products –
China being a primary example – turned to their customers for further sources of growth, mimicking the model of many developed nations.
PLENTY OF POSITIVES, BUT CHALLENGES REMAIN
Not all EM economies are moving at the same pace or implementing credible reforms, making for a wide dispersion in the level of returns across countries. Countries which have implemented fundamental structural and positive economic change, like China, South Korea, Chile and Russia are doing far better than repeat default offenders like Argentina and Venezuela.
Yet emerging markets on average are running more orthodox economic policies than many would think. Many influential economic policy makers and government ministers have been educated in the world’s best universities and come back to their home countries imbued with a belief in the benefits of neo-liberal and open-market policies. I would argue that some of the best economic administrations and central banks in the world are in emerging markets – Russia being a notable – if not always popular example. Asian nations themselves – and China in particular – have challenged the Washington Consensus and successfully developed an economic model where balance sheets are strong and the exchange rate float, but where the capital controls are in place to moderate the excesses of modern global finance.
On the economic front, balance sheets are therefore in good order generally – leverage is low, current accounts and government budgets in check, and policymakers encourage populations to save further, through pension and superannuation funds which are now reaching meaningful levels in places as far apart as Chile, Mexico, and South Korea.
The result is that these countries now have a considerable domestic pool of capital to draw on, something they have lacked in the past. EMs represent today for the first time about 50% of the world’s savings.
CHASING TOO FEW OPPORTUNITIES
In recognition of the resilience and attractiveness of the asset class, some of the world’s more progressive pension plans are seeking to aggressively expand into the emerging market debt space, ultimately overweighting the asset class in their global portfolios.
For investors looking for opportunities, however, the landscape can feel like too much money chasing too few opportunities. As economies grow, they naturally de-lever, further reducing the need for them to borrow and making the demand imbalance worse. Having a domestic pool of capital to draw on, combined with falling financing needs are obvious positives for these economies. But for institutional investors still underweight EM debt, there are barely enough international or domestic assets to satisfy their potential demand.
If domestic EM investors were to be successfully encouraged to move out of cash, where they are currently overwhelmingly invested, into diversified EM fixed interest portfolios, this would compound the imbalance further.
FINDING VALUE
From an investor’s perspective, EMD offers a unique set of diversified and scalable issuers with attractive ratings, compared with other asset classes. Interestingly it displays low correlation to more traditional asset classes as well. It represents more than 70% of the fixed income world – and more than 50% of investment grade bonds – with yields above 0%. In a world characterised by super-low interest rates and negative yields, there is positive yield and return still to be found in EMD across the board.
So, what about current valuations? In our view, valuations of emerging market investment grade bonds are currently unprepossessing: they are trading in the middle of a five-year range, offering decent carry but limited prospects of capital gains. There is arguably more value to be found in the higher-yielding sovereigns – such as the Ukraine and possibly distressed debt in Argentina and in high yield corporate debt, where spreads trades at three-year highs. We also see value in selected unhedged plays in local currency markets in Latin America, Eastern Europe and Asia.
When it comes to the future macro factors which will be driving returns, it is clear that the dovish stance of the world’s central banks – the ‘policy put’– is largely positive for emerging markets debt. There may also be fiscal stimulus to come from Europe, and we believe that there is ample room generally for fiscal stimulus around the world.
AN UNCONSTRAINED, FLEXIBLE STRATEGY IS KEY
Emerging market debt performance starts with income. Over the past 15 years, the income component of emerging market debt has accounted for more than 80% of both local and external returns and provided a steady annual income stream, in US dollars, of between 6%-8% gross.
The emerging market universe is no longer a bloc, rather, it is made up of 70 tradeable countries, 30 currencies and over 1,000 investable companies. Fundamental diversification between countries is imperative, bearing in mind factors likely to drive returns, because relative-value opportunities spring from the divergence between countries as well as well as unique opportunities which emerge from specific events.
Embracing active strategies is therefore important, since consistent alpha can only be found with the flexibility to time the market, select and de-select countries and strategies and the ability to systematically hedge the downside. Unsurprisingly, studies show EM total return managers achieve on average close to 85% of the market upside while capturing less than 61% of the downside. In August, 2019, Argentina served as a dramatic reminder of the risk to be exposed passively to EMs, when primary election results plunged the country into a new episode of market turmoil. In a year where the asset class provided investors with returns in excess of 10%, the Argentina index was down almost 40%.
In conclusion we argue that emerging market debt belongs to fixed income portfolios structurally because of its inherent characteristics of high income, diversification, low correlation to other asset classes, modest default rates and – in recent history – subdued volatility. And that the greatest returns over time will be made from portfolio construction which is index-aware but wary of falling into the trap of benchmark hugging.
Raf Biosse-Duplan is chief executive and EMD specialist at Finisterre.
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