Emerging Market Debt: A reconfiguring world
High credit spreads and strong currency performance are just two reasons why emerging debt markets are set to eclipse the performance of G7 countries in the coming year, writes Peter Marber
Fiscally, the global credit crisis has put most advanced industrialised governments between the proverbial rock and a hard place. Demographic imbalances, large public borrowing and high unemployment levels underscore a slower growth in the future for the US, Europe, and Japan.
In sharp contrast are emerging markets, whose v-shaped recovery in 2010 points to a very different economic story. In fact, one can easily conclude that emerging market fiscal dynamics - from Asia to Latin America - are far superior to those of Greece, Italy, Ireland, Portugal and Spain, and potentially the UK and US.
For good reasons, institutional investors have been diversifying beyond the G7 into emerging markets: developing countries comprise 85% of the world's population, 76% of the world's land and two thirds of the world's natural resources. Yet most investors have less than 5% of their assets in this arena. And emerging markets are expected to grow by 6% or more in the coming year according to the World Bank, triple the rate of the G7 countries.
While emerging market equities tend to grab the headlines, emerging market debt (EMD) has been the true, silent investment superstar: for 15 years ending 31 December 2009, a 50/50 blend of emerging market hard (foreign) currency and local debt EMD posted annual returns of 12.2% with 13.6% volatility, while emerging market equity has returned only 4.7% per annum in dollar terms with much higher volatility of 25%, according to Bloomberg.
That demonstrates how improving emerging market country fundamentals are better reflected in debt versus equity returns. In fact, had global bond investors swapped roughly 15% of advanced country government debt for EMD during those 15 years, they would have found an elusive investment Holy Grail: returns would have increased by 0.5% each year while reducing volatility by 0.5%.
Better policies, fewer risks?
The EMD universe - roughly 20% of the global bond marketplace - has blossomed since the crises of the 1990's, most of which were linked to flawed dollar-pegged monetary policies. With better fiscal discipline and free-float currencies, average emerging market inflation has fallen from over 100% average in 1990 to single digits today, according to the World Bank; in fact, many have G7 inflation levels. Moreover, for the last 15 years the ratio of government debt/GDP in emerging markets has held between 40-60%, while advanced economies have seen a huge uptick since the credit crisis, projected to be more than 100% in 2011, according to Fitch investor services (figure 1), and widely expected to swell further.
In contrast, emerging market country credit keeps improving, with more than 45 emerging market investment grade nations, according to Bloomberg. While emerging market dollar government bonds yielded less than 1.5% than US Treasuries at their tightest in early 2007, average spreads have widened during the credit crisis to 3.5% as of June 2010, according to JP Morgan.
The new ‘global'?
In addition to high credit spreads, investors should also consider local currency emerging market bonds. According to JP Morgan, returns have been impressive, particularly against G7 government bonds. For the 15 years ending in December 2009, emerging market local currency sovereign bonds have outperformed global hard currency debt by more than 3% per annum. And greater return potential still exists: currently, JP Morgan's local currency government emerging market bond index yielded roughly 6.5-7.0% in June 2010, versus 3% from G7 governments.
On a theoretical level, many emerging market currencies are also undervalued on a purchasing power parity (PPP) basis, and could appreciate like the Japanese yen did against the US dollar as Japan globalised after World War II.
While China's undervalued renminbi is one of the more obvious examples, there are many Asian, Latin, and African currencies that have theoretical appreciation potential of 20-50%. The numbers in figure 2 suggest that most mature economies have currencies that may be overvalued versus emerging market currencies, which look undervalued.
Clearly there are risks with emerging market debt. While defaults are the major one in hard currency bonds, local currency returns depend more on FX rates and shifts in local yields. However, as the market has truly broadened for emerging market local bonds, an investor's primary risk in a diversified portfolio EMD is volatility, the market price fluctuations that capture all the FX, interest-rate and political risks of the emerging market sector.
Interestingly, over time, emerging market debt volatility has dropped to G7 levels with all the policy improvements. At the same time, one needs to reconsider risk in buying G7 bonds at historically low yields being driven by relaxed monetary policies; rising rates - an inevitability - would only hurt returns. Moreover, do not underestimate structural risks in advanced economies. The Greek crisis has underscored potential weakness in other countries and the entire euro currency project. We can only speculate on the currency's future.
While there will always be occasional emerging market setbacks, a diversified EMD portfolio should hold up well considering better asset/liability management at the sovereign level; improved fiscal policies, including better trade and current accounts, floating-rate currencies which reduce the risk of imbalances, and record emerging market hard currency reserves that surpass emerging market hard currency liabilities and now stand at a remarkable $5trn (€3.8trn) or more - up from $1trn in the late 1990s - according to the World Bank.
A forward time bias
Many institutional investors, caught flatfooted by the global credit crisis, should be rethinking EMD bond weightings in the future. With fundamental economic improvements and momentum, investors should regard EMD as a higher-grade quality portfolio holding versus a high-risk sector. As part of this seminal shift, consider using dedicated EMD managers versus traditional ‘global' bond managers who occasionally dabble in EMD. Indeed, EMD managers have tended to add more value over time: according to Mercer Consulting, a median EMD manager for the last five years has beaten the benchmark by nearly 2% per annum, versus global bond managers who have generally only delivered benchmark returns.
Investors may also consider different weighting than traditional market cap indexes. Most fixed income indices, just like those for stocks, are heavily weighted by old industrialised countries that have more debt relative to GDP. That means that if you strictly follow market index weighting, you'll be owning a lot of debt from heavily indebted, older, slow-growing economies.
Long considered a peripheral asset class, EMD has performed well in the past decade and continues to offer compelling value. High credit spreads, attractive local currency yields, and potentially appreciating currencies stand in sharp contrast to current G7 bond markets.
Peter Marber is chief business strategist, emerging markets, at HSBC Global Asset Management, and also teaches at Columbia University