Part of the process of investing in emerging markets (EM) used to be that your double digit returns were gained alongside the very strong possibility that at some point, your portfolio would be engulfed in a wave of selling because of an individual country’s crisis. Things are changing: individual countries can experience a crisis that is no longer contagious and, although other emerging markets may experience some ‘tremors’, is not the universal blow-out that accompanied events like the Mexican peso devaluation in 1995 or the Russian default in 1998.
Kristin Ceva, lead strategist of emerging market bond portfolios at Payden & Rygel says :“If we look back at what happened following the Mexico and Russia crises, then all of the other emerging market countries followed suit. However, today there is a marked lack of contagion. In the last five years we have seen so many changes that have led to a lack of contagion in the (emerging) markets. Firstly, the credit quality has risen markedly to today’s level where almost 50% of the JPMorgan EMBI+ Index is at or above investment grade. Russia, for example achieved S&P’s investment grade this January. And it’s important to note that these spread compressions are not cyclical but structural.
“We will still see crises but they will be far less likely to affect a whole range of markets,” continues Ceva. “Although Argentina defaulted in 2001, all the other EM countries had positive returns by year-end. Each market is now far more contained. Country fundamentals in terms of the fiscal balances, the debt-to-GDP levels, and so on, are stronger. Many of the oil exporters for example now have current account surpluses. So the capital markets are generally much less vulnerable.”
Rob Drijkoningen, head of emerging market debt at ING IM, agrees that contagion is far less relevant today, as the surrounding countries have much stronger macro-fundamentals and stand on their own merits. He says: “Alongside these huge improvements in economic management, we have also seen great changes in the capital markets themselves. More countries are now able to carry out their funding by successfully issuing in their own local currencies. This would not have been possible in the past as investors would have demanded the ‘safety’ of a hard currency at least. Today, however, these countries are now able to rotate into their own currencies, which leads to the development of the local market. Building a local yield curve is the starting point from which the next layers can be added such as local government/state or corporates, international corporates then mortgage backeds and so on.”
Gorky Urquieta, ING’s deputy head of EM debt adds: “The local currency market capitalisation is about four times larger than that of the hard currency, and it is a growing universe. Investing in local currency used to be all about avoiding the big devaluations. However, as the macro fundamentals became so much more solid and the currencies were unhooked from their pegs and became more floating, the focus for successful investing has moved away from the strategy for avoiding the losers to one which involves picking the biggest winners.”
Ceva says: “We think the party is pretty much over for hard currency EM debt. Spreads on external debt have tightened to historically low levels. In certain countries, we see more value in local currency debt. There still exists a healthy yield pick up but we also have the potential for currency appreciation.”
Historically the local currency market was, in effect, a separate asset class to the hard currency. ING has been involved in local currency markets for some time through its insurance portfolios and these were separate from the hard currency portfolios. For many institutions with local liabilities, they have a natural, strategic need to invest locally. “It is now a lot easier for these institutions to do this,” suggests Drijkoningen. “Today we are mixing local and hard currency investments and have allocations to local currencies within our ‘hard’ currency portfolios.”
Jerome Booth, Ashmore IM’s head of research argues: “Since 2002, we have seen the US pension funds and institutions really moving into emerging market debt. After the stock market sell-off in 2000, pension funds were left underfunded, with annual target returns of 8-9% which they surely would not achieve from the S&P500. Their perceptions of risk have developed too: instead of asking ‘Is this investment risky?’ The questions now asked have to be: ‘Is this risk correctly priced? What is its correlation to other investments?’ There has also been a general realisation that in emerging markets we have a credit class that is not linked to the US business cycle, and they are thus a great way to diversify one’s assets.”
Ceva agrees: “The technicals (inflows) have been very strong over the last two years, and these have been driven by several factors. Many institutions have been structurally underweight and were traditionally not involved in EMs. However, attracted by the combination of the healthier macro-economic fundamentals, the high returns and very attractive Sharpe ratios, huge inflows have been absorbed by the EMs,” she says.
“The objective of many countries, in wishing to borrow locally rather than via hard currencies, is to decrease their vulnerability to external shocks. Although in the short term moving from dollar denominated to local currency denominated debt can increase volatility, in the longer term it reduces it. A borrower would like 30-year bond denominated locally at reasonable interest rate, owned domestically,” says Booth. “This increases policy options markedly, provides a sustainable source of borrowing, and allows the borrower to deepen local financial markets.”
So which countries’ local currency bonds will turn out to be this year’s ‘winners’? “We have been invested in Brazilian real estate in varying degrees,” says Drijkoningen, “although we have scaled it back because of the political uncertainties. And we have also been consistently overweight in Turkey, where fundamentals have been improving. 2006 will be an interesting one for Latin America especially where five nations have elections.”
Eastern Europe’s local currency markets have been developing faster than others. Monica Mastroberardino, portfolio manager of eastern European bonds at Swiss group Vontobel AM says: “There was a significant correction back in March/April after the ‘No’ vote from France and Denmark, which increased worries about whether joining the EU might mean even tougher conditions or whether the solidity of the EU itself should be questioned. It was quite a sharp correction at the time, but today things are looking pretty good again.”
Investors need to be careful as currency and yield levels have already discounted much of the good news. “We have to look at Germany to see what growth is doing there. If it strengthens then, with yields everywhere so low, eastern European markets would be vulnerable to sell-off.”
And what about China, the biggest emerging market of all? The recent currency move did not surprise many. Says Ceva, “The 2% revaluation was the smallest they could have done and we do not expect significantly more appreciation this year. This was a politically motivated move to appease the protectionists in the US.”
The managers at ING agree: “The policy makers are playing a brilliant game. Long term the Renminbi is a one-way bet, but that’s all pretty much discounted in the forwards.”
Booth suggests that China has learned from the Asian crisis. “China is not up against the wall. It’s not their currency which is hugely misaligned, it’s the US dollar – and they do not want to create a situation where excess capital is surging in before the Chinese banking system is strengthened. They need to create a vibrant bond market and a banking system that lends to companies instead of just buying US treasuries.
“What is the object of foreign exchange policy? I believe it is to decrease the uncertainties of what might happen in the future. China must continue to carry out the structural reforms, and build up the banking system. I think the recent currency move is a small victory for the reformers.”