Emerging market debt seems to be back in demand. And for good reason: inflation is generally falling, the growth differential between emerging markets (EMs) and developed markets (DMs) continues to widen, and current account balances are improving. In short, the outlook for EM bonds is looking far healthier than at any point in the last few years.
There’s clearly a spring in the step of a number of EM nations. While there are some lingering fears, it’s encouraging to see investors brushing aside concerns around Trump and his protectionist policies. Even the recent U.S. interest rate rise combined with a drop in oil prices has done little to dampen sentiment.
The U.S. dollar has actually weakened since the U.S. Federal Reserve (Fed) hiked rates earlier this month. It was a similar story after the last increase in December 2015. Many thought the U.S. dollar would strengthen, but in reality there was little movement, and EM currencies inched sideward with no defined trend.
Another cause for (relative) cheer is China. Over the last few years, a lot of capital has been withheld from EM debt funds due to fears of an imminent economic collapse. Too much cheap credit, overcapacity and capital outflows were supposed to be the country’s downfall. But the collapse has failed to materialize.
Instead, investors are finally beginning to conclude that China is not about to blow. Yes, debt levels remain an issue, but the economy is buoyant and is expected to grow 6.3% for 2017 (the equivalent of adding three Norways to its already titanic economy). But perhaps most important of all is the fact the Chinese government remains a vast domestic and international net creditor. For the first time in years, the positives may outweigh the negatives.
DM government bond yields are still near record lows. In Europe, there appears to be little in the way of value. The European Central Bank (ECB) seems to have exhausted its armory and is slowly tapering its quantitative easing program. In the U.S., equities have enjoyed years of Fed-driven asset price inflation, and prices have rallied further since Trump replaced Obama in the White House. But valuations now look stretched, and investors have grown wary. U.S. corporate bonds have also lost their shine, and returns on high-yield bonds are at multi-year lows while U.S. investment grade bonds are vulnerable to rises in U.S. interest rates.
It’s for the same reason that EM local currency (LC) debt is currently more attractive than hard currency (HC) dollar bonds. EM HC bonds, whether sovereign or corporate, are exposed to credit risk as well as interest rate risk.
Conversely, LC bonds are less affected by the fate of the U.S. and developed markets in general. Instead, local factors increasingly dictate interest rate risk – although it must be remembered that currency risk is an additional consideration for investors. That said, currency funding baskets, which include a mixture currencies can help to reduce risks.
And while EM economies are not perfect, no economy is.
Progress at the local level has been significant. And while EM economies are not perfect, no economy is. But governments and central banks across the EM regions deserve credit. Fiscal and monetary policy has been orthodox. When times were tough, they remained prudent. Monetary policy was not excessively loosened to stimulate growth and currencies were allowed to depreciate accordingly. This naturally led to some short-term pain, but the foundations for future growth and success were set. Inflation has now peaked, and demand for imports has swung trade and current accounts around, leading to less fundamental pressure on EM currencies. This has paved the way for central banks to begin cutting interest rates, which should subsequently lead to an appreciation among EM currencies. It’s a virtuous cycle.
Indeed, the average rating in the local currency index is investment grade. Debt levels are also low compared to DM nations with debt-to-GDP of around 40-50% versus 100%, respectively. Furthermore, those economies that have suffered the most in recent times, like Russia and Brazil, are bouncing back.
There are two ways of looking at the recent rally in EM bonds, albeit one briefly interrupted by the election of Trump. First, yield-starved investors had been forced to embrace the higher yields and supposedly higher risks on offer in emerging markets. Second, things have fundamentally improved and emerging market bonds offer genuine diversification benefits with the potential for decent returns. We subscribe to the latter view.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.