Investors should expect annualised returns of 9 to 9.5 per cent from emerging market local currency debt over the next five years, despite the fact it is “the most hated asset class on planet Earth”.
This is according to Jan Dehn, head of research at Ashmore. Dehn said that with yields on this asset class at 5 per cent, the impact of compounding means investors can expect to receive a five-year return of 27 per cent just by “sitting back and clipping the coupons”.
However, the manager pointed out this fails to take into account the price appreciation that is likely to result from the growing demand for emerging market local currency debt among developed market investors, particularly in Europe, who are flocking towards it “against their better prejudice”.
Dehn said the reasons behind its recent growth in popularity are fairly obvious.
“If you buy a bond with a negative yield, that is not an investment,” he explained. “It’s a tax because you have to pay the government to lend them money. This makes investors look for alternatives.
“The second reason why is, Europe is one slowdown ahead of the United States. Once the US enters its slowdown, its bonds will also go down to negative yields. And then there will not be a single bond left in the entire developed world with positive yields.
“US bonds are already negative in real terms, but they’re going to be negative in nominal terms as well once the Fed has cut 175 basis points.
“Many of the pension funds in Europe that are beginning to allocate money to emerging market debt are saying, ‘look, everybody’s aware of the coronavirus, everybody’s aware there’s a slowdown in China, everybody’s aware of Brexit, everybody’s aware of the trade war. All of these factors are really not very interesting’.
“And they’re not interesting because they’re all priced in.
“You can argue whether they are correctly priced or not. But we’re talking about marginal differences here. The real question over what is going to be driving markets over the next few years is all the stuff that’s not priced in yet.”
However, it is difficult to speculate about the source of such ‘unknown unknowns’.
Instead, Dehn said it is more useful to consider which areas of the market are likely to be hit hardest by any shock, which involves following the money trail of QE.
Most European institutional investor money has ended up in the S&P 500 and European debt – it is estimated that foreign investors have put $10trn into the US stock market since the start of quantitative easing, whereas they have opted for bonds in Europe due to the lack of growth and inflation.
If the global economy were to slow, the manager said this would only reinforce the value of European bonds. However, in such a risk-off environment, all of the foreign investors in the US equity market would quickly realise they are in the wrong place and would look for a better home for their money.
“That is really what matters,” Dehn continued. “As far as emerging markets are concerned, we estimate that a very small proportion of all the money that left the asset class has come back so far.
“If you look at like for like, compared with when the money left the asset class to where we are today, our assets under management ought to be around $156bn, but we are only at $98bn.
“We estimate US pension funds only have 1.5 per cent in emerging market fixed income compared with 6 per cent before the taper tantrum.
“So if you wonder why emerging market fixed income can perform as well as it has done over the last four years in the middle of a hiking cycle, trade wars, the slowdown in China, Brexit and all these other risks, part of the reason is simply that investors don’t own any of it – they will still have the same urges to sell emerging markets every time they get scared, but they don’t have any.
“And the bit that they have has outperformed developed market fixed income by multiple times, and therefore they are unlikely to sell it.”
While an influx of money will push up bond prices by itself, Dehn said this is also likely to lead to a second-order benefit for the asset class.
Emerging markets are currently financially constrained, which means there is a strong relationship between inflows and economic performance. As a result, increased exposure to emerging markets among international investors is likely to strengthen their currencies – which Dehn said look about 20 per cent too cheap compared with developed markets.
“That 20 per cent is going to be gradually eroded as money comes back into the asset class,” he continued.
“And that will give you an additional return in dollars of about 20 per cent. Not in a straight line, of course, because this is emerging markets forex and everybody has an irresistible urge to sell it every time they get scared.
“But over the four- or five-year period, this will materialise, and that leads to my total return expectation for emerging market local bonds of somewhere between 45 and 50 per cent over the next five years. If you annualise that, it works out to about 9 to 9.5 per cent return in dollars per year.
He added: “If you think that’s a completely insane pie-in-the-sky assumption, then let me remind you that over the last four years, emerging market local currency bonds – the most hated asset class on planet Earth – have delivered 11.4 per cent in dollars per year without any currency appreciation at all.
“The reason why the next five years are not going to deliver as much as in the previous four years is because the early bird gets the worm. The guys who went in four years ago are the ones who clearly understood the value and they got the bonds at the absolute cheapest point. The people who come in now are going to get a very decent reward, much better than anything they can get in developed economies, but they are not going to get as much as the guys who went in four years ago.”