The EM framing fallacy: Emerging market debt and the trials of a misunderstood asset class

How we frame things deeply affects how we process information and subsequently act on it. So much so that, despite convincing evidence to the contrary, it can be extremely hard to shake off a fabled preconception. It seems that once a label sticks it can be very hard to dislodge.

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3 minute read

Emerging markets are case in point. At worst, the label conjures up a misleading picture. At best, it fails to fully capture the nuances that lie behind each constituent country and issuer. Our behavioural quirks have conspired to lead many investors to structurally underweight emerging markets, particularly when it comes to allocating to debt.

Many of the facts that follow are well known but bear repeating if our cognitive errors are to be rebalanced.

Emerging markets now comprise around 60 per cent of the world’s economy in GDP terms.1 Although developed world populations stagnate and atrophy, emerging market populations are young and fecund; approximately 85 per cent of the world’s population, almost six and a half billion people, live in emerging markets.2

However, not only do they have young and vibrant workforces, the socioeconomic composition of their population is also shifting. The Brookings Institute has forecast the global middle class will double in the next ten years to reach 4.8 billion by 2030, with 79 per cent living in developing nations.3

Given their sheer demographic heft, it is perhaps unsurprising then that emerging markets are forecast to be the primary drivers of global growth in the years ahead. In its latest World Economic Outlook, the International Monetary Fund (IMF) has estimated the difference in economic growth rates between emerging and developed markets will nearly double over the next five years to 3.2 per cent.4 Extrapolating on current growth rates and emerging markets’ share of the global economy, the IMF expects their economies to contribute 84 per cent of global growth by 2024.5

Instruments within the emerging market debt universe have also proliferated – 257 per cent growth over the past decade – while the number of countries has jumped from 37 to 736 over the same period.

Time to take note – GCC benchmark addition

Growth within the emerging market debt universe accelerated further on 31 January when the Gulf Cooperation Council (GCC) officially joined the JP Morgan emerging market bond indices. The inclusion of sovereign and quasi-sovereign debt from Saudi Arabia, Qatar, Kuwait, the United Arab Emirates and Bahrain introduces a significant portion of highly-rated assets into the sovereign universe. Once the GCC phasing-in period completes in September 2019, around two-thirds of emerging market countries will be rated investment grade.

The skew towards investment grade can come as something of a surprise to many investors given the common perception that emerging market debt is a higher beta asset class and demonstrates the extent to which investor perceptions have failed to keep pace with reality. This gap has led to a structural mispricing of emerging market assets and can provide investors with attractive, steady, investment opportunities. By fully utilising the diverse universe of assets, active managers can adjust credit beta to provide a smoother path of strong risk-adjusted returns.

The increasing credit quality also strengthens the case for emerging market debt to become a structural holding rather tactical position within client portfolios.

Selectivity and investment discipline are still critical, however.  Currently, while the vast majority of higher-rated countries in the EM universe (those rated A, BBB and BB) have seen stable or improving credit metrics over the longer term, single-B rated countries in aggregate have experienced a deterioration. Geographic dispersion among the single-B names is significant, however, so country selection is key to generating attractive absolute and relative returns in this part of the EM universe.

Macro tailwinds

The macroeconomic environment also looks encouraging. Oil exporters are benefitting both from an uptick in the price of crude and, in the case of the GCC countries, from diversification efforts away from an over-reliance on petrochemicals to a more open and diversified economy. Oil prices have rallied by 40 per cent since the start of the year with Brent crude above $70 per barrel. Numerous indications, including conflict in Libya, Venezuela’s economic and political implosion and tighter US sanctions on Iran, which came into effect on May 2, suggest prices have some way to go yet.

Shifting central bank rhetoric has provided a further tailwind. At its last meeting in March, the Federal Reserve reversed its previous plan for two interest rate rises in 2019. The majority of Federal Open Market Committee members now expect no hikes in 2019 and just one in 2020. The dovish tone has been mirrored elsewhere with the European Central Bank suggesting rates should remain on hold through year-end. China, Canada, Japan and Britain have likewise signalled an accommodative stance.

Strong technicals

Technical factors are also positive. To date, this year has seen strong inflows with a bias toward hard currency assets. Data from JP Morgan showed almost US$23 billion flowed into emerging market debt funds in the first quarter with US$10.2 billion in January alone; almost two thirds the amount recorded in the whole of 2018.7

Despite the recent rally, valuations are attractive and supply dynamics in the form of limited issuance, provide a further tailwind. As a result, hard currency sovereign debt has performed strongly since the start of the year returning over 7 per cent8 to the end of April.

Proceed with care

However, although fundamentals are stable, challenges remain. Caution is advised with oil importing markets, such as Turkey, Indonesia and India, that are also heavily reliant on external funding to finance their current account deficit, as the trade-weighted dollar is near its most expensive in 20 years.

Additional risks include the synchronised slowdown in global growth and the continuing threat of trade skirmishes, particularly between the US and China. Last year commercial tensions, a deceleration in major economies and financial volatility translated into a fall in trade growth to three per cent versus the 3.9 per cent forecast by the World Trade Organisation. In 2019, the organisation forecasts growth of 2.6 per cent versus its previous estimate of three per cent9 and has also warned that global trade faces “strong headwinds” over the next two years.

In spite of this, the emerging market yield premium looks compelling given that, even if economic growth rates moderate, they are still likely to outstrip those of developed nations. And while they undoubtedly still experience higher levels of volatility than their developed market peers, the emerging market debt universe has undergone significant maturation as a result of a growing domestic investor base and sizable foreign institutional participation, which is less given to flight risk.

Given the positive macroeconomic backdrop, strong technical tailwind and the increasing skew towards investment grade, investors would do well to rid themselves of their long-held, and deep-rooted assumptions. Those who manage to reframe their thinking may find themselves both enlightened and surprised by the true nature of this misunderstood asset class.

References

  1. Referenceshttps://www.imf.org/external/datamapper/PPPSH@WEO/OEMDC/ADVEC/WEOWORLD
  2. https://www.imf.org/external/datamapper/LP@WEO/OEMDC/ADVEC/WEOWORLD
  3. https://siteresources.worldbank.org/EXTABCDE/Resources/7455676-1292528456380/7626791-1303141641402/7878676-1306699356046/Parallel-Sesssion-6-Homi-Kharas.pdf
  4. https://www.imf.org/en/Publications/WEO/Issues/2019/03/28/world-economic-outlook-april-2019
  5. https://www.imf.org/en/Publications/WEO/Issues/2019/03/28/world-economic-outlook-april-2019
  6. Emerging Markets Bond Index (EMBI®) Monitor March 2019 Month-End
  7. https://am.jpmorgan.com/de/institutional/library/weekly-bond-bulletin
  8. J.P. Morgan Asset Management; data as of 9 April 2019: https://am.jpmorgan.com/de/institutional/library/weekly-bond-bulletin
  9. https://www.wto.org/english/news_e/pres19_e/pr837_e.htm

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