Last year was dismal for EM debt. However, the asset class has rebounded strongly in 2016, with local currency bonds up around 15% year-to-date (JPMorgan GBI-EM Global Diversified index as at mid-September) – and there’s ample upside.
As we have noted in the past (e.g. The Rise and Rise of Emerging Markets), following a painful adjustment period EM economies are less vulnerable today than they have been in years. A sharp contraction in credit growth stymied demand for imports, so despite weak demand from developed markets and China for their own exports, trade balances have adjusted significantly. Capital flows, which had weighed on currencies, have finally returned to EM, and foreign currency reserves have stabilised, providing a crucial crutch to cheap valuations. Furthermore, we believe investors are being too cautious about EM growth prospects.
Drivers: growth and yield
Historically, a key driver of EM asset performance – both equities and fixed-income – has been the growth differential between EM and developed markets: as the growth differential widens, emerging markets outperform developed markets. Economists are generally forecasting this to happen in 2017, but we believe they are underestimating the impact of a positive credit impulse on growth and, therefore, the potential for EM outperformance.
This argument also underscores why we like Brazil so much: the improvement in its external accounts may be well acknowledged, but we believe the end of a negative credit impulse will spur better-than-expected growth, which in turn will help the country’s most pressing economic problem: its fiscal accounts.
The yield on emerging debt is highly attractive in a world where more than USD 12 trillion government bonds have negative yields. JPMorgan’s benchmark EM local bond index, the GBI-EM Global Diversified index, yields 6.2% – a pick-up versus comparable-duration US Treasuries and German Bunds of more than 5 percentage points and 6.6 percentage points, respectively.
This spread not only looks enticing: the additional yield is what will protect fixed income investors’ returns when bond yields rise (and prices fall). Although US Treasuries and Bunds are widely considered “risk-free”, they will be anything but when global growth and inflation recover, and central banks withdraw the extraordinary monetary stimulus we are reliant on today. Emerging market bond prices will fall in sympathy, but their generous yields mean total returns should be protected (assuming that spreads, which are wide relative to pre-crisis levels, remain broadly unchanged).
Local or hard currency?
One question that keeps cropping up is why invest in local currency instead of hard currency EM bonds? After all, hard currency has also performed strongly (if not quite as well) this year, and hasn’t suffered as much in previous years. However, hard currency debt will be more sensitive to any correction in developed market bond yields. Not only is it a much longer duration market, but higher US Treasury yields will overwhelm credit selection as the key driver of performance.
Local rates markets should offer greater differentiation, and therefore portfolio diversification, because individual central banks will be able to respond to an improving global growth scenario in different ways. Having employed conservative monetary policies already, for example, some central banks may be able to cut interest rates even as the US Federal Reserve is in a gradual hiking cycle; others may be forced to follow the Fed’s lead.
Additionally, hard currency debt is heavily owned already: a recent survey by JPMorgan showed that investors have record-high exposure to the asset class. Most critically, the outlook for EM currencies will be the key differentiating factor of returns between the two asset classes. The improving growth outlook we set out above should be supportive for currencies, thereby enabling investors to capture the higher yields on offer locally.
Indeed, our analysis shows that hard currency debt outperforms local when growth is hovering at low positive levels (as it has been in recent years), but as growth accelerates further – as we expect it to – it is local markets that perform best.
Tempering EM’s usual volatility
Of course, a bullish investment case does not guarantee a smooth ride. EM assets are prone to sudden shifts in sentiment, sometimes leading to sharp moves in either direction. For example, the GBI-EM Global Diversified index dropped more than 5% in August last year on China worries, while it jumped almost 10% in March of this year.
Many investors struggle to stomach this level of volatility. One way for them to gain exposure to the asset class could be via an absolute-return product, which has the ability to use short strategies (in rates and currencies, using derivatives) to partially hedge a structural long bias to the asset class. In exchange, investors sacrifice some of the upside as well, but the overall return profile should still be attractive given EM’s long-term prospects.
