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Emerging market fixed income has come a long way since the trials of 2013, says Liam Spillane.
A shift in Federal Reserve policy. Rising Treasury yields. Surging market volatility. Five years ago, the US central bank indicated it would wind down its bond-buying programme, prompting the so-called ‘taper tantrum’. Emerging markets were hit particularly hard by capital outflows during the ensuing financial turbulence.
Fast forward to February 2018, and many investors experienced an uncomfortable sense of déjà vu. Signs of tightening in the US labour market led to talk the new Fed Chairman Jerome Powell would be forced to raise interest rates more quickly than expected. Global equities nosedived and bond yields rose in many markets, as in 2013.
But the response of emerging markets was much more muted this time around. Although there was a brief sell off on the MSCI Emerging Markets Index, the 48 basis point rise in 10-year Treasury yields between January 1 and February 22 was comfortably absorbed into spreads on emerging market fixed income. The relative calm in emerging market debt is partly attributable to an improving macroeconomic backdrop, but it may also point to the increased resilience of the asset class itself.
It is easy to forget how far emerging markets have come since the troubles of the 1990s. Take the Mexican debt crisis of 1994, when a Federal Reserve rate hike left the Latin American country unable to service its dollar-denominated debts. Three years later, the Asian financial crisis was sparked by the sudden devaluation of Thailand’s currency, the baht, following the government’s decision to abandon a dollar peg. The turmoil that followed exposed the instability of many of the region’s currencies and the presence of large current-account deficits in many Asian economies.
Emerging markets made great strides over the following decade, improving their fiscal positions and taking greater control over monetary policy. Such was their progress that by 2013 many investors were convinced the larger emerging economies would be relatively insulated from Fed policy decisions. The taper tantrum proved them wrong: emerging market fixed income saw significant outflows in 2013, while hard-currency EM sovereign debt returned -5.25 per cent over the year.
But emerging markets have continued to grow deeper and more liquid since the trials of 2013. Fundamentals are strengthening, with debt-to-GDP levels relatively low and aggregate GDP growth outpacing that of developed markets (see charts). A divergence between emerging and developed market GDP tends to be accompanied by stronger portfolio flows and higher foreign direct investment, which should be supportive of further growth.
Emerging markets: current account balance (% of GDP)
Developed market vs emerging market GDP growth (%)
This is not to say that emerging markets are now completely insulated from policy shifts in developed economies. Part of the reason for the robust performance of EM debt in early 2018 is the synchronised global growth outlook (by contrast, the recovery was still relatively weak in 2013). It remains to be seen how EM debt markets would react to a steeper and more sudden rise in Treasury yields. And there is also the risk that a sudden reversal of flows from EM-focused exchange traded funds (ETFs) – which have proliferated since the taper tantrum – could stoke higher volatility.
But there is little doubt that emerging market debt is now much more resilient. EM currencies are no longer overvalued, as they were five years ago. And increased issuance of local-currency bonds in recent years is another positive sign.
As governments issue more debt in local currency the domestic buyer base grows broader, ensuring these markets are less vulnerable to the vagaries of global capital flows. Fixed income markets in Colombia, Peru and Chile, for example, are being buttressed by strong demand from local pension funds that must hold domestic debt for regulatory reasons. Local investors are also boosting liquidity in Russia, the Middle East and East Asia.
If sovereign issuers are in better health than in 2013, the same is true of companies. Default rates on emerging market credit dropped to a record low of below two per cent in 2017, and that figure expected to be only marginally higher this year. Strong balance sheets – as evidenced by low leverage levels and high cash balances – have meant that investors’ fears about issuers’ foreign currency mismatches have not been realised.
So what kinds of strategies would suit this improving outlook for EM debt? After a strong year for total returns in 2017, directional strategies are no longer likely to prove so lucrative and we expect correlations will begin to break down across both government and corporate bond markets this year.
While EM debt looks less vulnerable to a normalisation of Fed policy, investors will need to keep an eye on other macroeconomic and political risks. A slowdown in the Chinese economy – which is a possibility, given Beijing’s continued struggles to tame rampant public debt – could have a knock-on impact across other emerging economies. Investors should also monitor political risk. Twenty-seven emerging or frontier economies are due to go to the polls in 2018, and populist candidates could prevail in in Brazil and Mexico, two of the largest and most important emerging markets.
Elsewhere, however, the political situation is improving. South Africa’s prospects look much brighter under the new president Cyril Ramaphosa, who has vowed to tackle corruption. And in India, Narendra Modi’s reform programme is proceeding apace. With scope for further fiscal and economic reforms, both countries may represent opportunities in local currency debt.
In hard currency, we recommend looking beyond the obvious names. Frontier markets with capable administrations, especially those that have won the support of the IMF for reform programmes, may represent value for investors in government bonds. Central America (El Salvador), the Caribbean (Jamaica), and sub-Saharan Africa (Angola and Ghana) look particularly attractive, although local knowledge and expertise will be required to take advantage of opportunities in these markets.
- According to the JP Morgan EMBI Global Diversified Index.
- For a discussion of this trend see ‘Emerging markets have become more resilient,’ The Economist, October 2017
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