Emerging Market Debt: The real issue
Do negative real rates in inflating economies make a case for taking emerging currency exposure without the bond duration? Joseph Mariathasan finds a complex picture
Should local currency emerging market debt be seen as a core component of institutional portfolios? Certainly many portfolio managers would argue the case - the growing economic weight of the emerging world, their rising crediting ratings and the likelihood of at least long-term appreciation of their currencies makes for a compelling argument.
But Peter Ryan-Kane, head of portfolio advisory for Asia Pacific at Towers Watson, is not convinced. "The value in EMD is not that great," he says. "There is more smoke than fire. We are supportive of the idea of EM currencies doing well against developed. We are less supportive of EM bonds doing well. So the advice we give is that we like the currency, we like equities, but we are much less convinced over the bond story."
For those who would agree with Ryan-Kane, investing solely in emerging market currencies is certainly an option. Record Currency Management, for example, is a keen advocate of emerging market currencies quite separate from emerging market local currency bonds. It suggests that investors seeking duration in their emerging markets exposure could consider emerging currencies as an overlay on US Treasury portfolios, which are more liquid and more secure (in the sense of not being subject to potential capital controls).
Stephane Monier of Lombard Odier Investment Managers disagrees. Historically, Monier has seen two-thirds of the return arising from the bond component and one-third from the currency appreciation. "Over the past seven to eight years, interest rates have delivered 6% per annum with very low volatility," he observes. "The currency returns have also delivered 6% per annum but the currency return is highly volatile. In 2008 you would have lost your shirt. The volatility of the total is [almost entirely accounted for by] the volatility of the currency, so for the same level of risk I would prefer 12% return, rather than 6%."
Paul DeNoon, director of emerging market debt at AllianceBernstein, is even less enthusiastic over currency returns, seeing little near-term potential as a result of the global slowdown and decline in commodity prices.
"Over the six-to-nine-month time frame, the best bet is for generally stable currencies but we are looking for opportunities where central banks are looking to lower interest rates," he says. "We prefer debt over currencies. If you can have duration exposure and hedge out the currency, that would be what we would recommend."
It is the argument over inflationary pressures in emerging markets that lies at the core of Towers Watson's viewpoint. "In the US, there is substantial overcapacity and a process of deleveraging, so there is little inflationary pressure," explains Ryan-Kane. "In Asia, it is running at capacity and much of the Asian inflationary pressures are exogenous - in particular, food and energy prices. With debt portfolios, you want to be lending to people who are more likely to pay you back and in places where inflation is not likely to go up. So we prefer bonds in areas of low inflation. We are comfortable with developed market bonds and less comfortable with emerging markets. Some have argued that the credit fundamentals of emerging markets are improving. That may be right, but it is not strong enough to affect the growth profile affecting currencies and equities."
Ryan-Kane is also concerned about the potential impact of changes in central bank policy towards currencies. Chinese interest rates are negative in real terms because the renmimbi is being held back, so he is positive on that currency, for example. But keeping central bank policy rates low means real yields can be negative for a number of countries.
"Policy rates have been at low levels for some time," says Michael Gomez, emerging market debt portfolio manager at PIMCO. "From a rates perspective, controlling inflation has often been seen as less important than stimulating growth."
As Gomez explains, for its local currency debt portfolios, PIMCO seeks solid underlying credits with positive real rates and high nominal yields with an upward sloping curve. Brazil, Mexico and South Africa fall into that category with nominal yields of 5-10%. But it is very different in Asia, where he sees less value. The comparisons can be quite stark: "Brazil has 5% inflation with policy rates at 8.5%," Gomez observes. "Brazil also has a clean balance sheet from a fundamental perspective, so Brazilian central bank real policy rates of above 300bps look attractive. In Malaysia, the policy rate is 3% and inflation is 2%. In Thailand, inflation is around 3% and policy rates are 3%, while in Indonesia policy rates are at 5.75% and inflation at 4.5% and [in June 2011] it was at 6%."
This is the backdrop behind Ryan-Kane's view at Towers Watson that a "normalisation" of interest rates in these economies could result in a 20% loss in bond portfolios in a very short space of time. "That won't happen in the US," he notes.
But are Towers Watson's concerns of generalised inflation pressures in emerging markets justified? As Gomez points out, Asian economies tend to have strong balance sheets, high levels of international reserves and exports and growth-led policies that are much more tolerant of higher inflation. But he adds: "In Asia, there is a group of countries with fundamentally undervalued exchange rates. China and others, though, are now moving towards raising domestic consumption and having stronger currencies."
Extrapolating the past can therefore be misleading and generalisations can be dangerous.
As Paul DeNoon points out, while emerging markets share some characteristics, we are reaching the point when the differences are getting greater than the similarities.
"We have countries very different in policy mix, natural resource endowments, and political constraints," agrees Gomez. Comparing Turkey with Brazil, for example: inflation in Turkey was at 10% and is now coming down; monetary policy is heterodox; and it is a sub-investment grade credit. "We don't see great value in Turkey," he says. "Brazil is a significantly stronger credit than Turkey, with significantly lower inflation - over three percentage points lower - and has had much less volatile inflation over the past four to five years. The policy mix is easily understood in Brazil, yet yields in Turkey are much lower than in Brazil. It is a hard circle to square."
The heterogeneity of emerging markets can mean that exceptions are the rule for any grand theme.
"Productivity increases are still happening in emerging markets," says Jerome Booth at Ashmore Investment Management. "Will emerging markets have higher inflation than developed? It depends on what they are doing. There is much higher inflationary growth in the developed markets. Emerging markets in contrast, can achieve growth by spending on infrastructure."
Perhaps even more significantly, Booth argues that extrapolating from the past can lead to fundamental misconceptions. A lot of central banks in emerging markets, for example, cut their interest rates post-Lehman in the full knowledge that it was inappropriate for their domestic cycle but necessary to avoid a worse crisis. They knew they could have higher inflation in a couple of years' time, but Booth has the view that central bankers were more concerned over the possibility of a depression in the US, the onset of which would be quicker than the onset of inflation through the regular monetary cycle.
"When and if inflation arises, they can raise interest rates to curb it," he reasons. "They can also use their currency reserves to appreciate their currencies. Moreover, the electorates have gotten used to an era of low inflation, so they will be voting in politicians who have policies promoting that. The idea that emerging markets will have higher inflation because they are mismanaged is completely erroneous."
Perhaps the lesson that can be taken from the diverse opinions in the marketplace is that the distinctions between developed and emerging markets are breaking down so rapidly in the post-Lehman world, that it takes a brave person to make generalised statements towards debt in either category. The moves towards making the renminbi more of an international traded currency and increasing trade between emerging markets themselves suggests that the concept of emerging market local currency debt itself as a separate mandate might need to be re-examined sooner rather than later.