Payden & Rygel's Ehsan Iraniparast weighs up the pros and cons of emerging markets fixed income in 2014.
Following a challenging year, 2014 is offering a more upbeat backdrop for emerging markets. Strong economic fundamentals that have driven the asset class over several years remain largely intact, technical dynamics are supportive, and valuations have improved. Significant risks remain, however, and country differentiation and asset allocation will be a key theme this year. Recent volatility in emerging markets fixed income stems from two broad types of risk: those specific to the countries themselves, and those presented by a less predictable US/UK interest rate environment. Also, uneasiness persists regarding China's economic rebalancing.
Brazil's diminished growth prospects, anti-government protests in Turkey, and the Russia-Ukraine conflict are high-profile examples of sovereign risk that have damaged sentiment recently. These stories are balanced by countries such as Mexico, Colombia, and the Philippines that are reaping the rewards of market-friendly reforms. Several Eastern European countries are benefiting from an ongoing recovery in the European Union, while Sub-Saharan Africa presents a fresh selection of rapidly-expanding economies.
The sudden increase in US Treasury yields from May 2013 left investors anxious about the transition away from years of easy monetary policy. Though interest rates appear set to climb, the speed and magnitude will be muddled by conflicting signals about the US and global economic recovery. Importantly, subdued inflation is allowing major central banks to commit to a low rate environment looking into 2015.
Diversified opportunities in emerging markets fixed income ensure that not all assets have or will perform similarly. Within local markets, Hungary, Romania and Nigeria delivered positive returns in US dollar terms in 2013. In hard currency bonds, many high yield sovereigns posted gains, moderating the losses in interest rate sensitive investment-grade securities. Emerging market corporates have been more resilient on whole, given their shorter duration profile.
The yield back-up across assets has provided an improved entry point for investors. The spread on hard currency sovereigns, at about 300 basis points over US Treasuries, is near the 10-year average. Emerging market corporate bonds offer significant spread premiums over similarly rated developed country corporates, and emerging markets' domestic interest rate differentials are near five-year highs versus US Treasuries. Meanwhile, emerging economies maintain their growth edge, and run more balanced budgets. Public indebtedness in emerging markets has fallen from 50% to 35% of gross domestic product over ten years, while developed countries have levered up significantly. The enhanced credit quality of the asset class, at 66% investment-grade – versus just 35% a decade ago – is a testament to this progress.
Fund inflows, a positive technical force over several years, showed vulnerability beginning in May 2013 as retail investors reduced exposure. However, institutional investors represent approximately 80% of the investor base in emerging markets debt. Data shows that pension, insurance, and sovereign wealth funds have steadily allocated to the asset class, often using corrections as a buying opportunity.
The maturing of emerging markets now allows investors to manage the various country-specific sources of risk; opportunities for diversification – both of countries and assets – are greater than ever. There are 61 "index-eligible" emerging market countries today, having doubled over 10 years. Emerging countries' domestic currency debt markets have grown and are multiples larger than traditional hard currency markets, providing access to distinct monetary policy cycles.
Economic development has also facilitated access to global debt markets by the private sector. Corporate issuance in US dollars has been robust recent years, and predominantly high-grade. Companies' foreign exchange risk is often mitigated by prudent hedging strategies or deriving revenues in major currencies. Emerging market corporates offer investors further differentiation opportunities, providing exposure to nuanced trends in retail, energy, banking, industrials, or telecommunications.
This year will present its own set of challenges. In addition to US interest rate volatility, emerging markets face a heavy electoral calendar in 2014. Prominent countries such as Brazil, Turkey, India, Indonesia, and South Africa are going to the polls. While election outcomes serve as an important barometer of reform momentum, the institutional capacity of these countries has reached a stage where shifting political tides will not portend radical policy changes.
Finally, economic prospects for the UK and US are improving, while the Eurozone is emerging from recession. If these trends take hold, they can spur a cyclical revival in emerging economies to complement their positive long-term structural dynamics. Despite the various headwinds, emerging markets are poised to maintain their attraction for fixed income investors over shorter and longer time horizons.
Written by Ehsan Iraniparast, emerging markets country analyst, Payden & Rygel
