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Impact Investing

IPE special report May 2018

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Outlook: The case for EM debt

Opinions vary on the long-term prospects for emerging market debt. Joseph Mariathasan reports 

Emerging market debt has become too large a set of asset classes to ignore but opinions on its prospects are mixed. 

Simon Lue Fong, the head of emerging market debt (EMD) at Pictet Asset Management, is bearish. “There are four factors that explain 70% of the returns for the main benchmark index (the JP Morgan GBI EM Global Diversified index): US Treasuries, the euro/dollar exchange rate, commodity prices and global inflation,” he says. “With US Treasury yields heading upwards, a strong dollar and weak commodity prices, the outlook is not very positive.” 

But Stuart Sclater Booth, a portfolio manager at Stone Harbor Investment Partners, says it is essential to separate the long-term structural factors that continue to support EMD, particularly local currency debt, from short term cyclical effects. Over the past three years the latter have created the perfect storm for emerging market currencies. He views the most challenging factors as the low growth in the world economy, weak commodity prices and the uncertainty over global monetary policy and the US Federal Reserve in particular. 

But as Sclater Booth points out, these headwinds have been known for some time and market prices have been adjusting to them. “Valuations in EMD, particularly local currency debt, are very compelling now after a three to four year decline,” he says. “Yields have risen relative to developed markets significantly, whilst currencies have depreciated. So the conditions for outperformance are there when we get a catalyst.”

He says the long-term prospects for emerging markets are still positive. “There is a lagged effect from US growth which, as it picks up, will be very beneficial to global growth generally and emerging markets in particular where growth rates are at a bottom; commodity prices look more stable with oil prices self regulating, albeit at lower levels than the past; finally, with respect to Fed policy, we are currently in a period of maximum uncertainty but everyone is expecting a Fed hike which will be managed with kid gloves by the Fed with significant amounts of forward guidance to limit the volatility in markets.” 

As Sergio Trigo Paz, the head of EMD at BlackRock, argues, when rates are rising slowly, investors need to be in an asset class that has a cushion enabling positive returns to be maintained. 

GDP growth in emerging economies is still outpacing that in the developed world

“Hard currency EMD is offering more than 350bp [basis points] over US Treasuries and 66% of the market is investment grade,” he says. Longer term, the emerging market differentials are still there with better growth and cheaper currencies. Emerging market balance sheets look strong and higher GDP growth than developed economies is backed by better demographics. Inflationary pressures are being controlled as central banks have become focused on inflation targeting. Disorderly currency depreciations are not an issue, as countries have built up enormous reserves while also shifting to much greater reliance on their own local currency debt markets.

One reason why there is a large divergence in views on EMD is that there has never been as much dispersion in the underlying economic conditions for emerging markets as at present.  Trigo Paz points to three reasons for this variation: “Firstly, there is dispersion in growth across emerging markets. 

“Valuations in EMD, particularly local currency debt, are very compelling now after a three to four-year decline” 
Stuart Sclater Booth

“Secondly, the growth dispersion has led to big differences in monetary policy. Some countries have to hike rates while others have to cut them and some cannot do either. 

“Thirdly, there is dispersion in the economic environment between commodity exporters and commodity importers.” What this presents, says Trigo Paz, is opportunities for active managers. The beta for the sub classes will be different; in 2014, hard currency sovereign debt delivered 6%, local currency fell by 5% while corporate debt showed a 3% return. “This means that the asset allocation decision is fundamental for institutional investors,” Trigo Paz concludes.

If long-term prospects are attractive, what are the risks? Ricardo Adrogué, the head of EMD at Babson Capital Management identifies two key risks. First, the pace at which the Fed has tightened rates in the past and what the Fed is saying the path will be today are fundamentally different. “The Fed only cares about the US,” says Adrogué. “If rates are hiked too much, giving high real interest rates, it could be very detrimental to emerging markets.” 

Second, China has become important for emerging markets overall. Adrogué says: “It used to be said that when the Fed caught a cold, emerging markets contracted pneumonia. But that could be said today of China. Its importance to emerging markets today is equivalent to the importance of the US in the 1980s and 1990s.” 

The unreliability of China’s GDP figures themselves pose a risk. There is relatively little transparency on the Asian giant’s economic transformation. It is unclear whether China’s slowdown is a result of a policy initiative or underlying weakness. The former would be a positive and the latter, a worry.

Ignoring EMD should not be an option for institutional investors. But understanding how to best approach the promise held out by the assets class takes some care.

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    Asset class: Real Estate - Core Open-ended Real Estate Equity Fund (non-listed).
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