EMD: take pride, not prejudice
John Peta, head of emerging market debt, Old Mutual Global Investors
After weeks of continuing turbulence in global bond markets, investors are once again asking themselves “where next for fixed income markets?”
There is, even among some seasoned fixed income investors, something of a tendency to see emerging markets in terms that we believe to be too simplistic. Over the last decade we have seen the rating agencies, the markets and now the average person realise that the traditional developed markets are not the bedrock that they historically have been and neither are emerging markets the basket cases that some have characterised them as.
Indeed, the World Bank classifications of low, middle and high income (of which emerging market countries are generally regarded as being in the bottom two, and developed market countries in the top) now place countries such as Chile, Poland, Uruguay and Russia in the high income category. Similarly, from a default risk perspective, the team at Old Mutual has identified over 12 emerging market countries for which the credit default swap (CDS) market indicates a lower risk of default than Spain and Italy.
It is relatively easy, on the face of it, to see why misperceptions about emerging markets have arisen. A good example can be found in a comparison of Italian and Czech government bonds. In the early 1990s, Italian government debt was rated AAA, while Czech debt was rated BBB.
Yet it was not always thus, and in some respects this disparity was an accident of history, with the Czech Republic having found itself on the “wrong” side of the Iron Curtain, a fact that weighed on the country’s sovereign rating long after the fall of Communism in Europe. The onset of the Eurozone crisis saw Italy’s rating steadily deteriorate, so that it is now BBB-, while the Czech Republic’s rating has risen to AA-. The key reason for this exchange of places is illustrated by two simple statistics: Italy’s debt-to-GDP ratio is 134%, while the Czech ratio is 44%.
It is a remarkably similar story for Greece and Turkey, with the later generally viewed as an “emerging” market, while Greece was considered a “developed market”. Greece is now rated CCC+, with 175% debt-to-GDP, while Turkey is BB+ and has a 37% debt-to-GDP ratio.
What may surprise some investors is that these examples are not isolated ones, as borne out by aggregated figures: on average, emerging market countries have a debt-to-GDP ratio of 35%, versus 95% in developed market countries. This pattern only looks likely to become further entrenched, given consensus forecasts for the next five years that indicate emerging market economic growth should outstrip that of developed markets by some 3.5% per annum (Source: Bloomberg: weighted average, net debt, 2013 full-year GDP).
Enlightened investors are increasingly recognising the diversity of the emerging market debt asset class.
There are approximately 190 countries in the world, of which some 25 are developed. This leaves 165 countries that are potential emerging market investments. The picture is similar in the currency markets: there are essentially 12 developed market currencies, and over 80 different emerging market currencies.
A key tenet of investment management is finding different sources of alpha. Given QE in the US, Japan, UK and now Europe, correlations in G7 markets are at very high levels. Emerging markets are generally less correlated due the differing levels of credit quality, monetary stance and political risk.
Indeed, within emerging markets we have seen a significant rotation: China’s economic picture has been deteriorating, although its growth rate still seems attractive on a relative basis. Meanwhile, India’s new reformist government is undertaking significant changes, which in turn are feeding into the economy and inflation expectations. India’s growth rate is likely to overtake China in the near future.
For investors, this only increases the importance of taking idiosyncratic positions. The challenge is to identify the markets that really are attractive, implying that there should be attractive opportunities for active managers to add value.
Aside from arguments about how misunderstood emerging markets are, and how much diversity they offer, perhaps the most persuasive of all from an investor’s perspective is their long-term return prospects.
Since the summer of 2013, emerging market debt has been somewhat out of favour due to expectations of the Federal Reserve’s normalisation of interest rates and its corresponding shock to emerging markets. At the same time, quantitative easing (an extraordinary measure) has led to better returns from developed market bonds than the vast majority of investors had expected.
Looking ahead, we believe monetary stimulus will continue to support developed equity markets, but less so the bond markets. Clearly, the best forecast of future expected return from a bond is the yield. On this measure, we would argue that quantitative easing has made developed market bonds a virtual desert of opportunity for those investors looking for attractive long-term returns from their fixed income portfolios.
By stark contrast, the emerging market debt universe is so full of opportunities, it more closely resembles a complex jungle – potentially very fertile hunting ground, but not without potential pitfalls.
This is not, of course, to suggest that developed market government bonds have no part to play; indeed, their role as a (relative) safe-haven during periods of severe market stress shouldn’t be understated.
Once again, the figures tend to speak for themselves: developed market government bond yields are 1.5%, with an average maturity of 9.25 years. Meanwhile, local currency emerging market yields average 6.5% (external currency emerging market yields average 5.78%), with a 7.2-year average maturity.
To some investors, these figures will come as something of a surprise. Recognition is increasingly widespread, however, that emerging market debt is scarcely the esoteric asset class it was once thought of as being. But for those who might have been put off even considering an allocation to emerging market debt in the past, figures like these only reinforce the case for reappraising the asset class.
All data: source: Bloomberg, as at 03/06/15, unless otherwise indicated.