Emerging market debt will experience a five-year recovery from this point onwards, according to Ashmore Group’s Jan Dehn (pictured), who said the market area boasts attractive yields and strong fundamentals. 
In contrast, the head of research warned that developed market bonds will start to struggle as they become increasingly overbought by investors.
He said this shift in dynamics will be gradual due to bearish sentiment from the average investor when it comes to emerging market debt, and that high valuations and low yields across developed markets will eventually drag them “kicking and screaming” into the sector.
“Emerging markets have issued $18.5trn of the world’s debt – so out of the $100trn of debt in the whole world, emerging market debt accounts for just 20 per cent,” Dehn explained.
“But emerging markets are nearly 60 per cent of global GDP, so it’s immediately obvious that emerging markets are finance constrained.
“Some 80 per cent of the world’s bond financing is invested in just 40 per cent of the world’s GDP and 20 per cent is invested in 60 per cent, which is of course why emerging markets have high positive real yields and developed market equities are negative across the board.
“When that much money chases bonds in a relatively small part of the world, and there is such little money chasing the big part of the world, then naturally the bond prices will be different.”
The head of research said the use of quantitative easing (QE) in the US, the UK and Europe following the financial crisis exacerbated this mass allocation of capital as, when governments bought bonds, this of course increased the price of the asset class.
He described QE as a “giant magnet for capital” which then encouraged investors to further sell out of emerging market debt and into already-overbought developed market debt as they anticipated further loose monetary policy.
“For emerging markets this was a problem and not just because asset prices fell as a result; as investors left the asset class they sold local currency bonds in particular, so emerging market currencies fell by 45 per cent on average between 2010 and 2015,” Dehn explained.
Performance of currencies vs US dollar between 2010 and start of 2016
Source: FE Analytics
“Bond yields kept rising because people kept selling the bonds. So, at several points both in 2015 and 2016, we saw the average bond yield in emerging markets rise to 7.25 per cent on 4.5-year duration government bonds.
“To put that in context, that is a higher yield than we had in emerging markets in 2006 before the global financial crisis began and when the Fed had interest rates fully normalised at 5.25 per cent.”
As such, he said it was unsurprising that growth slowed across emerging markets over this time frame. What is interesting, according to the head of research, is that there were surprisingly few corporate defaults across emerging markets despite the challenging backdrop. He also said that, other than in a small handful of the most vulnerable frontier markets, the IMF (International Monetary Fund) had to roll out very few stabilisation programmes across developing countries.
“The emerging market debt rally is accelerating this year,” Dehn continued. “The big question going forwards is what is going to drive asset price performance – how much can emerging markets make and what are the limitations to those returns?
Performance of index in 2017
Source: FE Analytics
“It’s quite important to understand this within the context of the global shift in capital that occurred. Because investors frankly have lost sight of underlying fundamentals and basically have just chased momentum created by central banks.
“Whenever that happens you end up with these big gaps between valuations and fundamentals, then at some point those gaps have to be closed and that is essentially a process that is happening now.
“I think this process is going to play out over several years. I think we’re only really in the beginning of the reallocation of capital out of QE markets and back into the non-QE markets including emerging markets.”
The head of research said this process will be relatively slow for two reasons. Firstly, he pointed out that investors are often myopic and tend to focus on recent events and market movements as opposed to those that have happened several years ago.
As such, he said the recent volatility seen in emerging markets is likely to weigh on investors’ minds more than its positive returns several years ago.
Performance of index since start of data
Source: FE Analytics
Secondly, given that many investors are now so heavily exposed to developed market bonds, Dehn said they are likely to feel a sense of trepidation when completely reallocating their capital.
“If you own a developed market bond right now with negative real yields at a time then the US is reaching full employment, the Federal Reserve is still 125bp in negative real territory in Fed funds rates, Trump is about to do more QE and the prospect for rising inflation is significant then you have no protection through negative bond yields, at all,” he warned.
“Developed market bonds are going to make outright losses in the next five years, European bonds have already started making outright losses, other developed markets will over time.”
Dehn said Ashmore recently conducted an informal survey of their US pensions client base. In 2013, 6 per cent of their overall fixed income allocation was in emerging market debt on average and, in when asked again at the end of 2016, this proportion had fallen to just 2 per cent.
Given that 98 per cent of their fixed income allocation is likely to fill them with trepidation while the other 2 per cent is performing positively, the head of research argued that negative sentiment is going to dominate.
“If you’re feeling scared overall, you don’t buy emerging markets because investors still think emerging markets is a bit of a casino play,” he explained.
“So for these two reasons, I think the flow back into emerging markets is going to be relatively gentle and relatively protracted, almost as if investors are going to be dragged kicking and screaming back into this asset class.
“When I look forward and I try to predict what the outlook is for the market, I’m looking at a five-year recovery for emerging markets, not just one year.
“It took five years for the money to leave and that was actually quite quick. For the money to come back it’s going to be very slow. I think the five-year horizon for the outlook is a reasonable way to look at it.”