A growing number of smart investors believe it’s time to raise strategic allocations to emerging market (EM) debt, and have been putting their money where their mouth is. There are good reasons for this optimism; conditions are the most favourable they have been in years for the asset class, says Sergei Strigo, Head of Emerging Market Debt and Currency at fund house Amundi. This article considers why, and how investors should play it.
First and foremost, in the current low-yield environment, in which some traditional fixed income assets are providing negative yields, EM bonds are an attractive yield enhancer.
Given ultra-loose policy by the Bank of Japan (BoJ) and European Central Bank (ECB), as well as US Federal Reserve dovishness, developed market (DM) yields are at historical lows. Some 97% of DM sovereign bonds now offer less than 2.5% of yield, with 30% offering negative yields. In comparison, BBB rated EM local currency (LC) offers 6.4% and EM hard currency (HC) sovereigns offer 6% for BB+ rated index, according to JP Morgan’s EM bond index.
While the US is set to hike rates again by the end of this year, the ECB and BoJ are doing the opposite, notes Strigo. “So if you look at global rates overall, they will probably remain low for some time.”
He adds that the Fed is now globally data dependent and not just focused on US economic factors. This means the pace of US policy normalisation will be extremely sluggish, even in an environment of relatively healthy US growth.
Moreover, the Fed is now sensitive to dollar strength and views it negatively. “We think this spells the end of the structural secular dollar appreciation cycle,” notes Strigo, “which is very positive for EM currencies.”
Another reason to back EM debt is the surprising resilience of its fundamentals. EMs have had a lot of bad press in the past several months, if not years, says Strigo. As a result, they have been heavily oversold for no good reason. EM growth may have slowed, but other macroeconomic indicators – such as current account balances – have been improving meaningfully. Countries such as Russia and Hungary are enjoying sizeable surpluses of 4-5% of GDP, whilst previously large current account deficit countries such as Brazil and Indonesia have seen a sharp rebalancing. EM governments are managing the slowdown better than they have done at other times in the past 20 years, argues Strigo. “We don’t expect a return to the Asian financial crisis scenario,” he adds, “ as we don’t see risks on the same scale as in 1997/98.”
Something else that has changed since back then is that the size of the EM debt pool has grown significantly to more than $15 trillion from below $1 trillion in 2000. In recent months, EM bonds were more liquid than traditional fixed income assets, so investors enhanced their portfolio liquidity by investing in EM debt, says Strigo. It’s likely that this liquidity has been boosted by recent stimulus measures carried out by the ECB and BoJ.
Indeed, the latest round of ECB stimulus delivered in March is even better for emerging markets than the ‘bazooka’ in January 2015. This is because the ECB easing no longer appears targeted at weakening the euro, and that makes it easier for EM currencies to perform.
Moreover, the provision of liquidity by the BoJ and ECB looks set to continue for some time given the relatively slow growth and below-target inflation – something that will be beneficial for EM bonds, notes Strigo.
Commodity cycle benefits
EM debt investors should also be heartened by the state of the commodity price cycle, and by the political cycle in commodity exporting countries. Inefficient and market-unfriendly policy measures adopted by many EM commodity producers were masked by the boom years of commodity prices, notes Abbas Ameli-Renani, global EM strategist at Amundi. Those policies were exposed as commodity prices came crashing down in 2014 and 2015, he adds, with significant political ramifications that bode well for the medium-term EM outlook.
For example, there has been the recent victory in Argentina of President Mauricio Macri; the Venezuelan opposition winning a qualified majority in parliament, raising the possibility of an impeachment of President Nicholas Maduro; and the impeachment of Dilma Rouseff in Brazil. Further, the impeachment of South African president Jacob Zuma is possible in the next 12 months.
Of course, such outcomes do not imply the end of EM political risk, but suggest that governance could improve, notes Ameli-Renani. This should be set against rising political concerns in developed markets, with the prospect of a British exit from Europe, US presidential election, key polls in Germany and France in 2017, Europe’s immigration crisis and so on.
How to play it
So EM debt exposure is clearly desirable, but how should investors play it? A key question is whether to buy debt in local or hard currency, the latter usually referring to dollar or euro issuance. Given the selloff of EM local bonds over the past three years, there’s more upside in LC bonds, but Amundi remains more comfortable investing in HC debt, says Ameli-Renani. One of the key drivers of currency is growth, and since the firm does not yet envisage a meaningful pickup in EM growth, it does not expect a sustained strengthening of EM currencies, he notes.
Interestingly, a quarter of respondents to AsianInvestor’s poll question on this area said they bought LC debt and hedged the foreign exchange risk (see graph, left). Ameli-Renani said he would not recommend that approach: “It means you basically lose all of your yield and become very reliant on the appreciation of the bond itself. If you don’t want currency risk, you are better off investing in hard-currency issues.” On average, the yield on dollar-denominated debt is substantially greater than on currency-hedged local-currency denominated debt, he explains.
Time to return
In light of the compelling evidence, investors should be allocating a greater amount of their fixed income allocations to EM bonds, said Strigo. “We still think that institutional EM debt allocations are very light and it takes several months, if not years for them to invest, but slowly that’s what they’re doing.” Following the ‘taper tantrum’ in 2013, many allocators exited EM debt and never really came back. It’s time they did.
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