Revisiting the strategic case for emerging markets, we believe that a number of factors remain unchanged and should underpin growth, including young and large pools of labour, sizeable commodity reserves, significant potential for productivity gains as economies become more service-led, positive reform agendas and much stronger fiscal balance sheets than the western world.
DeleveragingYet whilst many of the positive drivers of emerging markets over the last decade remain unchanged, we believe that the dynamics of the asset class will be slightly different over the next three to five years with two additional likely themes arising.
Whilst at times, such as the recent sell-off, the markets may react with nervousness to changing dynamics, overall we believe the superior long-term growth potential in emerging markets will allow them as a whole to attract more than sufficient capital, underpinning asset prices. Below, we examine these changing dynamics and their likely effects in more detail.
Deleveraging in the West and the emergence of a stronger consumer in emerging markets mean the global economy is rebalancing.
The trend of export-led growth in emerging markets, driven by an ever levered-up western consumer, has come to an end.
As a result, current account balances are likely to move from significant surpluses into modest deficits for many countries.
We believe this represents a return to historic ‘normality’ as the financing of Western current account deficits by capital from emerging markets is an unusual situation.
An end to QE
A second and crucial difference is the likely slow but steady withdrawal of easy money. While the Fed’s tapering of QE is likely to be modest and interest rate tightening much further away, the easy money that has lifted all ships is unlikely to be maintained on a three to five year view.
Current account deficits mean a greater reliance on foreign direct investments and portfolio flows. But given tighter global conditions, competition for this capital among emerging markets will become greater.
At times, such as the recent sell-off, the markets may be nervous about these flows in general. However, overall we believe the superior long-term growth potential in emerging markets will allow emerging markets as a whole to attract more than sufficient capital, underpinning asset prices.
Furthermore, country selection will likely become more important in managing emerging market debt portfolios. Countries with more investor-friendly policies, better growth dynamics and stronger competitive positions in terms of exports should fare better.
Higher protection
Looking to emerging markets debt, we believe that with relatively low duration and a high starting yield, local emerging market debt offers protection, especially in case of a gradual move higher in yields.
After falling to multi year lows of 5.15 per cent, local currency bond yields saw their most aggressive one month increase in two years to 6.60 per cent, underlining our view that yields are back in a 6 per cent-7 per cent fair value range.
Recent flows and the help of QE meant bond yields had overshot to the downside at the beginning of May, with risks now more evenly balanced.
Based on positive carry and our belief that monetary policy rates are anchored by benign inflation, we expect positive absolute returns.
Spreads
An analysis of real emerging market yields compared with developed real yields shows that spreads are at multi-year highs.
In addition, we expect this spread to converge slowly but surely over time as emerging market central banks become more credible in fighting inflation.
On an absolute basis, real yields have moved closer to what we would view as long-term value, but remain somewhat expensive as both developed and emerging market real yields have been compressed by global QE.
Emerging market real yields are also anchored by high savings rates, lower growth and lower inflation risk premiums.
High yields
Looking next at yields for sovereign and corporate debt, spreads and yields are close to fair value in historical terms.
However, if we return to a yield-seeking world, hard currency debt is likely to stand out as very attractive.
In such an environment, at close to 6 per cent, sovereign and corporate debt offer great carry without the volatility of currencies.
In addition, corporate yields are still superior relative to comparable developed market debt with similar credit metrics.
This is especially attractive given likely credit improvements in both the sovereign and corporate space, albeit at slower pace than the last decade.
Currencies
Emerging market currencies in dollar terms have moved broadly sideways over the past few years, even though economic theory would predict a modest upward trend.
The latest drop was modest compared with the sell-off in September 2011, as this time bonds bore more of the brunt of the falls.
Looking at theoretic valuations more closely, the Balassa-Samuelson theory states that emerging market currencies are expected to appreciate with productivity gains and growth in GDP per capita.
We estimated the potential returns from currencies based on current valuations (using purchasing power parity), the Balassa-Samuelson effect as well as inflation and interest rate differentials.
On average, the annual appreciation based on this measure over the next three to five years is 2.9 per cent.
The current starting point gives one of the larger potential appreciations we have seen historically, up 1.8 per cent from earlier in the year.
We believe part of the reason is that implied yields on currencies have increased from about 4 per cent to over 6 per cent.
Of course, spot currency moves lower have also added to value creation. We have stress-tested this number for smaller growth deviations between emerging and developed markets, but the effect of a 1 per cent smaller gap in growth is modest.
Conclusion
On a relative basis, our analysis shows that emerging market bonds again look particularly attractive versus developed market bonds, and with spreads back above the long-term average, we expect emerging market bonds to outperform developed market bonds.
Granted, investors are nervous that the slowing of QE and a rise in US rates could reverse the capital inflows to emerging market debt.
However, we believe outflows will actually moderate as higher yields and better news keep investors engaged and better entry levels emerge.
Nonetheless, it will be important to differentiate the winners from the losers. Country selection is likely to become an important factor in managing emerging market debt portfolios.
Indeed, the recent weakness in the asset class has thrown up some interesting relative value trade ideas and we have taken advantage of the correction to take up positions which we believe can generate more consistent outperformance in the current environment.