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Emerging markets debt in Goldilocks situation
EMERGING markets debt (EMD) has staged a strong recovery this year with total inflow already at US$25 billion, the highest since 2012. The recovery is particularly impressive in EM local currency debt, with a total return of 14.7 per cent in US dollar terms this year as at the end of July, nearly reversing the entire weak performance in 2015.
In this article, we explain why EMD continues to be an attractive diversification in a global bond portfolio in the current environment.
We see five reasons to support why EMD is an attractive diversification in a global fixed portfolio.
- Dovish world central banks and benign global inflation. We expect key global central banks (especially the US Federal Reserve, the European Central Bank and the Bank of Japan) to remain very accommodative for the foreseeable future to revive growth. Modest growth (but as long as there is no recession), together with benign inflation, provides the Goldilocks external backdrop for EMD.
In the IMF's latest Word Economic Outlook, the Fund forecasts global growth to be 3 per cent and 3.4 per cent in its baseline scenario for 2016 and 2017 respectively. The forecast for EM growth stands at 4.1 per cent and 4.6 per cent for 2016 and 2017 respectively.
- Yield enhancement returns. With over 25 per cent of developed markets (DM) sovereign bond yield being negative, the crave for yield is becoming increasingly strong. Based on the JP Hard Currency EMD Benchmark Index, the average yield for USD EMD is around 5.5 per cent (average rating BB) as at the end of June, which offers around 400 basis point yield pickup over US Treasury.
The yield enhancement is even more pronounced in local currency debt, which is yielding around 6.4 per cent (average rating BBB). As this suppressed yield in developed market countries continues, the demand for EMD is set to grow, most likely in hard currency debt initially and eventually into local currency as the outlook for EM growth improves.
- Improving fundamentals in EM economies. After a series of economics shocks (such as the Fed taper, the collapse in commodities prices and concerns over China) and various (geo)political risks (such as Brazil and Russia) in the past few years, we are expecting to see some recovery in EM growth.
Many EM economies have undergone substantial adjustments, especially via FX depreciation. This is noticeable in the reduction in both the current account deficits and short-term external financing needs. With our expectation that Fed tightening would be extremely gradual, commodity prices bottoming at current levels and no hard landing in China, we expect EM growth to recover to 4-6 per cent over the next five years on average.
On the election front, we had a heavy election agenda in 2015 in emerging market nations. Hence, we expect political noise to subside, especially compared with the busy schedule in the developed market world.
- Investible universe and good diversification. Total investable EM debt stock outstanding is roughly US$15 trillion, which is around 15 per cent of the world debt. Geographically speaking, there are up to 60 countries with diverse economic cycles and around 500 corporates to invest in. This offers good diversification and reduces concentration risk.
- Underinvested asset class. According to the IIF EM debt monitor March 2016, total global debt across all sectors (ie including private debt) was around 26 per cent of total debt in the world.
EM growth is contributing to 57 per cent of global growth, and yet only 10 per cent of total debt portfolio is allocated to EMD. With the inclusion of RMB into the SDR basket, we believe EM currency's share in global foreign reserves can only increase from here. These all point to higher demand for EMD in the future.
Different types of EMD
There are three main types of EMD funds:
- Hard Currency Sovereign. This group primarily invests in EM sovereigns in G-4 currencies. Investors are taking country credit risk but no currency risk. Hard currency is the most well established out of the three groups and is particular popular with investors who are concerned with FX volatility.
- Hard Currency Corporate. This group became fashionable in 2011 when the hunt for yield resulted in a surge in the demand and issuance for corporate bonds. Investors are investing in the non-sovereign credit risk without any FX risk.
- Local Currency Sovereign. This group became popular around 2008 when EM growth outlook was rosy, boosting FX returns. Investors are taking both local duration and currency risks. After the sell-off in EMFX in the last few years, we believe positioning in local currency is still light among GFI investors.
With our view that EM growth will continue to recover, we believe local currency debt offers a high potential in returns over the medium term, especially with a very gradual hiking path from the Fed.
EMFX - what now?
The outlook for EMFX is a key for local currency debt. We think EM countries were right to use EMFX as a shock absorber, and we believe the most violent adjustment in EMFX is behind us for now based on our views that:
- external vulnerabilities for many EM countries have fallen;
- the strong bull USD trend is potentially behind us with the Fed likely to hike very gradually;
- commodity prices have bottomed; and
- no more sharp FX depreciation nor hard landing in China.
We also observe that EMFX is becoming less sensitive to any hawkish Fed surprises. The volatility of EM currencies has also been falling compared with DM peers with the ratio between the two at the lowest since 2013.
In conclusion, we are constructive on EMD and believe this asset class offers good diversification in the current low yield global context. While our strongest conviction right now remains in hard currency debt, we also like local bond duration.
On EMFX, further volatility cannot be ruled out, but the most violent adjustment should be behind us, thus improving the returns potential for local currency debt.
This article was contributed by Amundi Asset Management