Over the last decade, emerging market (EM) countries implemented numerous structural improvements in their fiscal and monetary policies which helped them to achieve substantial improvements in their sovereign balance sheets, inflation rates and productivity levels.  These factors have been, and should continue to be, key drivers of sovereign credit quality and currency performance. 

 

Today, many developed market countries are attempting to make structural changes similar to those put in place by EM countries in the late 1990s and early 2000s.  It is for this reason that we feel that both EM credit and currencies are potentially attractive asset classes long-term and should be structural allocations in any well diversified portfolio. 

 

Nevertheless, in the short-run, just like any other risk asset, we feel that there are three factors that are going to present some challenges:  First, over the course of the first quarter of 2012, investors have progressively accumulated larger allocations to EM fixed income, in an environment where interbank liquidity has contracted substantially on the back of increasing regulation. 

 

Second, the US current account deficit has decreased substantially since 2007 (from close to six percent of GDP to roughly 3.5 percent of GDP now), and it is likely to continue to correct as the US government tightens fiscal policy in 2013, which should have a positive impact on the US dollar.  Third, the stress faced by Europe, combined with the risk of a substantial fiscal tightening in the US in early 2013, are going to continue to weigh on risk assets.  The direct consequence of these challenges is that volatility in EM assets will probably increase relative to what we experienced in the first quarter of 2012. 

 

For this reason, already in March, we started to reduce the overall risk profile of our portfolios, and focussed our risk taking on high grade quasi-sovereign and corporate companies in high credit quality countries, substantially reducing our exposure to EM currencies and to weaker sovereign credits.  We feel that at the current juncture, the risk/reward proposition of external debt looks more attractive than that of local currency denominated bonds.

 

In terms of external debt, with a yield of 5.71 percent, plus a roll-down of close to 150 bps p.a. of the JP Morgan EMBIG index (external debt benchmark), it would be reasonable to expect returns to be in the mid to high single digits over the next year. This is provided the G3 central banks remain relatively accommodative, the European authorities manage to prevent a significant contagion of the Greek situation, and the US authorities manage to scale into the fiscal adjustment in 2013 rather that march head on into the proverbial fiscal cliff.  Although what we state here might not be the market consensus, we think that there is a more than fair probability for all three of the conditions stated above to materialize.  

 

With regards to EM currencies, the short-term valuation indicators that we track suggest that by late April of 2012, currencies had become somewhat overvalued (roughly six percent according to our estimates for the EM currency index) while positioning was crowded.  Since the end of April, the EM currency index has corrected by close to four percentage points, erasing a large part of such overvaluation.  However, when we consider that the yield on the blend of the EM currency and local bond indexes is roughly 5.40 percent, and the roll-down on this blend is of approximately 0.80 percent per annum, if currencies remained absolutely stable, this index should also be able to produce a mid to high single digit return over the course of 12 months, but there are two key issues to keep in mind.  

 

First, EM bonds denominated in local currencies are almost twice as volatile as bonds denominated in USD.  Second, the reduction in the US current account deficit is going to make it harder for all currencies to appreciate against the USD, as was the case for most of the last decade.  As a consequence, the risk/reward proposition has shifted as of late in favour of USD denominated EM debt over the near-term (six to 12 months).  During this period and until there is more clarity on the outcomes of the European situation and the US fiscal adjustment, the focus of risk taking should remain in external debt, while currency exposures should be dialed up and down more tactically.