EMERGING markets debt has gained traction among investors in the recent years, and with good reason. In the past year, emerging market local currency bonds have been the place to be. With the dollar strengthening, many wonder if emerging markets local currency bonds can maintain that position.
Historically, currencies of emerging economies have been sensitive to the US dollar as its value directly affects their debt metrics (and the cost of servicing it) as well as the financing of their current and/or capital account deficits – where applicable. However, this is less true than before, for three main reasons.
First, emerging economies have less external imbalances than they used to have. Second, local currency debt markets have developed fast, allowing domestic borrowers to reduce their relative exposure to the dollar. Third, most emerging currencies restored their competitiveness during the deep adjustment they endured between 2013 and 2016. Besides that, the dollar is still in a declining trend and unlikely to bottom out, as long as the current US administration continues to fan the flames of the twin deficits and to broadcast its anti-global trade rhetoric.
Looking at Asia, where we have an underweight, we see a big and growing market in EM Corporates. However, the big part of investor base is local-based. About 90% on average of the demand for new issues in China, for instance, comes from Asian investors, and China is by far the biggest part of Asian EM Corporates. This technical factor drives the yields considerably and, for that reason, the risk/reward on average does not seem justified as compared to other regions.
However, as active and contrarian investors, we tend to look for idiosyncratic individual stories in different parts of the market. We manage to find stories in Asia as well, it is just because there are fewer of them, that we are underweight this region. Issuers from some other countries, like Indonesia, for instance, have certain corporate governance problems, which make the credit premium unjustifiably low in most of the cases.
In Latin America we have an overweight as we see attractive qualities there. Latin American issuers tend to pay more in yield in general than their Eastern European, Middle Eastern or Asian counterparts in the last few years. The reasons for this include an international investor base (particularly US investors), less interventionist and more liberalized regimes prevailing, driving volatility in times of political uncertainty, and the Brazil corruption investigations of the past few years that roiled the markets across the region.
Besides, the region is very diversified in terms of sector exposure thanks to its richness in natural resources and big domestic consumer market. In the end, given we are looking for specific opportunities across countries and sectors, the fact that we are overweight LatAm is just a function of there being more of such credit-specific stories or market inefficiencies in the more general sense.
Rising interest rates and inflation have taken the centre stage for some investors when thinking about EM debt. We agree that the secular disinflation trend of emerging economies is losing steam and could even be interrupted by rising commodity prices (energy, metals, food) and some base effects. However, we believe it is way too soon to call for the reversal of this trend as few emerging economies are anywhere near closing their output gaps – a sine qua non condition to see their core inflation picking up. In addition, real yields in local currency bonds are generally still attractive and, for choice, offer a better cushion than their developed market counterparts.
Looking ahead, the markets are developing rapidly, making it hard to predict with any reasonable degree of precision. One trend that is very likely to persist is the growth of the asset class. For example, an increasing number of new issuers are coming to market. New sub-classes may also appear. Before 2008, for instance, there were very few examples of EM Corporate-dedicated funds and the asset sub-class was about US$500 billion in size, providing very limited opportunities for investors looking for decorrelation with decent liquidity.
Currently, the space is US$2 trillion and more funds are being launched, as investors increasingly turn their attention to this part of the market. Another example is EUR-denominated issues. As the negative/low yield environment started to prevail since the mid-2010s, issuers from emerging markets became very active and tap this market regularly since then.
When it comes to favourite sectors, as highly-active and contrarian investors, we tend to look on particular bottom-up stories more than on top-down region/country/sector view, although we certainly pay a lot of attention to the latter as well. For that reason, we tend to see more value in those corners of the market, where some activity is present here and now. 2018 is a big year in the emerging markets, because two of the major countries – Mexico and Brazil – face extremely influential presidential elections. That creates volatility and, therefore, opportunities.
Overall, we prefer to be diversified across different sectors, as it is never easy to predict from where the next big sell-off will come. Any sectors could see changes, which is why we like to have exposure in all or most of the sectors present globally. What matters for the fund is more value within any sub-category of bonds, such as a global mining company or a relatively small port operator. It is important to have protection against natural FX risk.
Emerging markets is a fast-growing asset class with about US$3 trillion of bonds across sovereign and corporate issuers, and we believe portfolio flows into emerging markets will increase. In the long term, emerging markets fixed income remains a very rewarding asset class, despite popular perceptions of it being risky. If an investor had invested into emerging markets debt at the worst possible moment – in 2007 (before the global financial crisis) – his or her returns would be double the returns of US Treasuries and roughly match those of S&P 500, but with much lower volatility.
Investors who are deciding how much of their portfolios to allocate to EM should bear in mind that emerging market benchmarks have lower duration than their peers in developed markets. Those that are cautious about the monetary normalization among US/EU and other economies therefore increase in rates get to benefit from bearing less rate-increase risk. In combination with higher spreads for comparable ratings, emerging markets are attractive for investors.
Luc D’hooge is head of emerging markets bonds, Vontobel Asset Management
