Emerging markets shine for yield seekers
Contrary to popular belief, emerging markets are returning to favour as investors seek yield away from mature and often expensive financial markets in the developed world.
While many retail investors are yet to realise the opportunities presented by emerging markets, professional investors are increasingly tapping into the potential for these markets to deliver a level of yield that is no longer possible from many developed economies, notably the US and parts of Europe.
Emerging market bonds in particular have gained traction in recent months, with the JP Morgan EMBI Global Core Index, a benchmark index of US dollar-denominated emerging market government bonds, achieving total returns of 10.2% in 2016.
The higher prospective returns on certain emerging market bonds, compared to lower-yielding mainstream bonds, have both stoked investor demand and lured prospective issuers to market; a number of emerging market governments, including Brazil and Turkey, returned to bond markets in 2016 to sell new bonds to investors.
‘We’ve been quite positive on emerging markets as an asset class in recent months,’ says Chris Iggo, chief investment officer for global fixed income at AXA Investment Managers.
‘From a tactical point of view that has been driven by a number of things – the macro cycle, attractive valuations and the diversification opportunity.’
AXA IM expects stronger GDP growth for emerging markets in 2017 led by continued recoveries in some of the major countries that suffered a recession in recent years.
It follows a rocky road for emerging markets economics after the US Federal Reserve announced in May 2013 that it would begin to taper a monetary stimulus program that saw it pump $70 billion a month into financial markets by buying bonds and mortgage-backed securities.
The news hit riskier assets hardest, particularly emerging markets. ‘The taper tantrum created volatility in emerging markets, sending bond yields higher and leading to capital outflows,’ says Iggo.
‘The commodities price collapse of 2014/15 amplified the downturn, but a recovery got underway last year, led by commodity-producing countries like Brazil, Russia, Argentina and Indonesia.’
Credit market conditions have historically been a good economic barometer. Deteriorating credit conditions, measured by widening spreads, have generally been associated with slower growth, while tighter spreads tend to coincide with faster growth.
The narrowing of spreads has been a good contributor to the performance of emerging market fixed income of late, but valuations remain attractive.
‘Yields and spreads are higher than what is achievable in developed markets, therefore enabling us to create portfolios with much higher yield capacity,’ says Iggo.
Diversification of risk is a core reason for investing in global bond markets, even though yields, particularly in the west, remain low.
Emerging markets encompass a large number of countries and sectors, issuing a huge number of bonds. The debt market is worth an estimated $1.7 trillion– one-fifth of the entire dollar-denominated fixed income market globally1.
‘It’s big, it’s liquid and very diversified in terms of country issuers, sectors and individual companies,’ says Iggo. ‘There’s lots of scope for finding decent quality credit stories.’
For example, yields on emerging market investment grade credit are currently 4.24%, whereas the yield on US and European investment grade are 3.18% and 0.88% respectively2.
The diversification offered by fixed income markets make them fertile ground for total return strategies. Taking a broad universe of fixed income sub-asset classes, total returns so far this year3 have ranged from -1.5% for European inflation-linked bonds to +5.9% for hard currency emerging market debt.
‘The relative performance of different parts of the bond market is driven by macro trends and that means there are always relative value and performance opportunities if a bond exposure is diversified and actively managed,’ adds Iggo.
Risks and rewards
Despite this positive sentiment, emerging markets can also present many risks. Much of that comes from macroeconomic and political factors.
In May, less than a year after Brazil’s previous president, Dilma Rousseff, was impeached following corruption allegations, the country was plunged into another corruption scandal, this time involving current president Michel Temer, who was previously Rousseff’s vice president.
‘Corruption and suspected linkages between government and big business pervade lots of emerging market countries and is something that needs to be kept in mind,’ says Iggo.
Volatility in commodities prices is another big risk. The oil price has experienced further volatility of late, with another dip pushing it back below $50 per barrel. Oil price weakness puts pressure on emerging markets that are big producers of oil – Brazil, South Africa and Indonesia.
‘It normally means the currencies of these countries weaken against the US dollar, which creates an issue for domestic economic policy,’ says Iggo.
Potential returns, however, are attractive relative to the risks. For emerging markets, good macroeconomic fundamentals matter, and early and decisive measures to strengthen macroeconomic policies and reduce vulnerabilities help to dampen market reactions to external shocks.
‘Even with the significant recession some of these economies went through, we didn’t see big increases in defaults; if investors had stuck with their positions over recent years they would have earned a decent premium over time,’ says Iggo.
‘Debt levels are also a lot lower than in western economies – government debt to GDP is a lot lower, which is positive for financial stability.’
Assessing the relative merits of different assets and locations in emerging markets is imperative. Robust analysis of the macroeconomic prospects is a big part of investment decision-making.
‘We are looking for countries that are well-managed and have less political risk,’ says Iggo. ‘So we probably wouldn’t invest in Venezuela, but we might invest in Columbia.’
In Paraguay, he would consider government bonds but not corporate debt due to the country’s stable political landscape and scarcity of quality debt issuers, while in Brazil the opposite is true.
‘There is too much sovereign risk due to political scandals, but corporate governance is good and lots of export-driven companies are benefiting from weakness in the exchange rate,’ says Iggo.
Less conviction for China
In China, he is wary of both government and corporate debt despite data pointing to an improving macroeconomic picture. The Chinese economy grew by 6.9% in the first quarter of this year, reducing the risk of a Chinese hard landing, and monthly trade data shows that Chinese exports and imports are surging relative to a year ago and a negative performance during 2015/16.
‘Despite shorter-term economic improvements we’re concerned about China’s economic growth model going forwards. Its transformation from an export focused, capital investment model to a domestic driven model is going to take time and will expose industries with too much debt,’ says Iggo.
More positively, China and the broader Asian economy stand to benefit from the advent of a new tech cycle as the production of the next iPhone gets underway.
However, bond yields are very low, leading AXA IM to be significantly underweight Asian fixed income. ‘It’s an expensive asset class that is not generating a sufficient level of yield for us,’ adds Iggo.