Using emerging economies to beat the crunch

Emerging market debt as an asset class is at something of a crossroads. Although the expansion of emerging markets has slowed, they still enjoy a positive growth differential over western economies, and the asset has been capable of generating near equity-like returns without full equity risk, with many funds achieving double digit growth in the majority of the last ten years. Like most other asset classes they slid in the last quarter of 2008, but in the first few weeks of 2009 a new fear of credit ‘landmines’ has gripped some parts of the market. The market for debt in these regions remains inefficient, creating opportunities for active management, and the asset class is still seen as introducing at least a degree of diversification into a portfolio, but a lot depends on the developing world’s ability to grow independently of the west and that has begun to disappoint. Many managers are still bullish. “While emerging markets are not decoupling from the malaise of the developed world, the developed world undoubtedly remains at the epicentre of the crisis,” argues Alexander Kozhemiakin, director of emerging market strategies at Standish, part of BNY Mellon Asset Management. “Emerging markets are continuing to attract positive flows of capital. Consumption across the region will grow and so will return on these investments,” he explains. Growing influence The extent to which emerging markets are likely to become major contributors to global growth relative to the developed world is escalating fast, according to Michael Thompson, head of European institutional remarketing at Pimco. Five years ago emerging markets contributed 40 per cent to global Gross Domestic Product, while three years ago this rose to 50 per cent and last year emerging markets accounted for some 75 per cent, Mr Thompson says. The diversification story also stood up relatively well until last October when correlation between different asset classes spiked. Even including that period the correlation of emerging market bonds to the S&P 500 has been 0.65 per cent on average for the last five years, compared with, say, a 0.8-0.9 per cent correlation between international equities. “These countries have bypassed the credit crunch and are the only place to be in terms of real economic diversification,” claims Jerome Booth, head of research at emerging market specialist Ashmore. “Broadly speaking, emerging markets do not have excessive leverage because they have experience of being cut off from capital many times before. The exception is Eastern Europe, but excessive leverage is not an issue for banks in Asia that were at the centre of the panic in 1997 and learned from that to be more risk averse,” he says. Mr Booth expects debt in the region to recover before equities, in a fairly quick V-shape recovery, compared with western markets where the process will be more protracted. “History,” he says, “tells us that if there is banking crisis associated with recession it takes longer to recover.” Safety in surpluses Many of these countries have come a long way and are now less likely to default because they have built up solid current account surpluses and their central banks have become more proactive. However, those with current account deficits such as Turkey, South Africa and Vietnam have been soundly punished. Until recently, fund managers were able to benefit from the credit crisis as forced sellers such as hedge funds offloaded their holdings in the face of heavy redemptions, making it possible to pick up paper at 65 cents and sell it at par a month later. “After a year like last year, we’re in a pretty good position but we’re not expecting a spectacular rally from now on,” says Paul McNamara at Augustus Asset Managers, formerly known as Julius Baer. “We just think the asset’s risk reward in terms of the likely default relative to yield offers a lot of value. The creditworthiness of credit in the region is stronger than people think,” he adds. As emerging markets mature, many bond issuers prefer to issue their paper in their local currency because it leaves them less vulnerable to currency fluctuations. Funds are therefore generally divided into those that invest in dollar-denominated paper and increasingly those that invest in local currency debt. Surprisingly, the local currency market is now estimated at $900bn (€670bn) compared with just $200bn for external sovereign debt. “When people talk about emerging market debt, they’re typically talking about dollar-denominated debt in countries like Brazil, Mexico and Malaysia, but three quarters of emerging market debt is in local currency, and most of the trading volume is in local currency,” says Mr Kozhemiakin at Standish. “The distinction is critical as dollar debt is viewed like corporate bonds in that what matters most is the spread over Treasuries, with returns generated when spreads tighten,” he adds. “For local currency debt, spreads are less meaningful because return will be based on both currency and local interest rates. Liquidity in local currencies is better than elsewhere and we are still seeing markets in these bonds – Chilean pension plans will still need to buy long-dated bonds, for example,” says Mr Kozhemiakin. Returns from local currency debt are driven by both currency movements and interest rates and as more emerging market countries allow their currencies to float, a weakening dollar created profits for investors. Currency movements can of course just as swiftly wipe out gains if a manager makes a poor call, and as many of these countries move away from pegging their currencies to the US dollar, the volatility of individual currencies will rise. Dual identity Local currency bonds enjoy both sides of their dual identity of being both credits traded in international capital markets and also their standing as the highest rated instruments in their own currency, attracting conservative, risk averse indigenous investors. On the whole, dollar-denominated emerging market debt struggles to achieve attractive returns, whereas local currency debt has the potential for double-digit performance. The local debt market is also a larger, more diversified universe, enabling fund managers to continue delivering even when individual countries have underperformed and creating new opportunities wherever new economies develop swiftly to fill the vacuum left by those that have been upgraded to investment grade status. A recent trend, for example, has been to build positions in Africa. Currency appreciation has been a significant driver of returns in recent years. Most of the regions’ currencies experienced a sell-off and the rise in yields delivered positive returns, with disinflationary expectations also helping support the market at the tail-end of last year, but the future is less certain. “Local currencies have been encouraging as they have been functional,” says Mr McNamara at Augustus. “There is reasonable liquidity and local institutions have supported the market, but we are more positive on bonds than on currencies. We don’t see a big rally in currencies but rather a move to sustainable levels,” he explains. Another characteristic of the middle of last year was that many funds chose to invest more heavily in corporate debt rather than government debt, but that proved ill-judged because governments in these regions had been reducing their debt while corporates had been busy issuing paper. For example, the BNY Mellon fund invested almost exclusively in local market Government debt and benefited from its scarcity premium. That balance has been changing since the start of the year, as governments return to bond issuance to take advantage of the dramatic drop in yields. The Philippines, Turkey, Brazil and Colombia all issued debt in the first week of the new year, raising a total of $4.5bn (E3.46bn) compared with just one deal worth $2bn from Mexico issued in last quarter of 2008. Pimco’s Mr Thompson says there is a bifurcation between countries with fiscal discipline and those that haven’t or have not been in a position to exercise control. One of the preferred countries is Brazil which has made long-term structural progress, has reserves of $200bn, and now offers long term rates that are among the highest in the world. No significant waves of corporate problems or defaults are anticipated and while the country is experiencing a slowdown in exports, it is more or less a closed economy and in many ways braced for a strong recovery. The Argentine peso is also extremely undervalued, but markets have been disappointed by erratic and unorthodox policies of the Argentine government, though that could change. Other favoured issuers have been Venezuela and Ecuador. No time for bargains But sentiment on the most promising economies has also shifted since the start of the year, with a renewed appetite for eastern European markets such as Hungary, Poland and Turkey where there is a good policy set up, rather than bargain hunting in riskier markets. Uncertainty about the outlook has led Pimco to postpone the launch of an Asian local currency bond product until 2010 so that it can assess the situation. Others remain concerned about the current account deficits prevailing in Eastern Europe. “Eighteen months ago it was all about exotic markets,” says Mr McNamara at Augustus, “but we can now make decent money out of core European markets. It’s a move if you like away from commodity-based economies to screwdriver economies that are heavily involved in manufacturing.” Strategically investors have long been underweight the sector. While retail investors are still heavily biased towards equities, emerging market debt had been becoming sought after by pension funds and other institutions attracted to its potentially high returns and diversification benefits. Central banks also have to manage their reserves and the asset class has been a great hedge against dollar weakness, particularly as US treasury yields were very low and spreads widening. Pimco’s Mr Thompson says investors are now much more discerning about how they want to spend their allocation to this asset class and many will need to rethink their allocation to risk, particularly as interest rates are forced down to zero.