Investors in emerging market debt can count themselves lucky. For the past 10 years the asset class has delivered higher returns on an annual basis than any other debt product, including US high yield and investment grade. What’s more the outlook for emerging markets remains strong. Economic fundamentals in most developing countries are good and getting better. This, in turn, is fuelling greater participation from stable long-term investors such as asset managers and pension funds. What risks there are lie in the broader economic uncertainties of the US and China.
One of these uncertainties is a higher US interest rate. So far interest rates have risen by 1% this year to 2%. Historically, whenever US interest rates enter a tightening cycle, it has spelled disaster for emerging markets. “If volatility measures go up in the US, this will have a knock-on effect on sub-credit markets,” says Alex Kriekhaus, portfolio manager at Fisher, Francis Trees & Watts. This was most evident in the early 1990s, when a tightening in interest rates triggered a currency crisis in Mexico.
This year, however, emerging markets have weathered any potential interest rate storm. Admittedly there was a big sell-off in April and May as investors initially took fright of an increase in US rates. But over time, money has returned to the asset class as fund managers have begun to price in further interest rate hikes. In fact, emerging markets spreads have tightened over the current interest rate tightening cycle to 394bp over US Treasuries (November 9) from 418bp over at the beginning of the year.
“The difference [between now and previous interest rate tightening cycles] is that investors became risk averse ahead of the first interest rate hike,” says a JP Morgan report published in October. At the same time, it adds, “fundamentals have been on an uptrend since 2002.”
Today, emerging markets current accounts show an overall surplus of 0.8% of GDP, compared to an overall deficit of 1.7% of GDP in 1995. A range of governments across all regions has abandoned fixed exchange rate regimes, which made countries vulnerable to interest rate changes before. External debt ratios have also fallen.
According to Michael Roche, head of global emerging market fixed income at HSBC, these are long-term improvements. “There has been some courageous policymaking in emerging markets in reaction to the forces of globalization,” he says. “This is a continuous process of improving economic efficiency.”
Susanne Gahler, fund manager at F&C Asset Management, supports this view. “Interest rates are important for emerging markets, because they are capital importers and have considerable financing needs. But the majority now have trade and current account surpluses.” This means, that financing needs are decreasing and that even if US interest rates reach 4% the impact should not be as harmful as before.
The picture varies from country to country and, according to Mohamed El-Erian, emerging market portfolio manager at Pimco, investors should be careful not to treat emerging markets as a homogenous group. Varying degrees of political uncertainty and differences in countries’ dependency on commodity prices account for disparities in their economic outlook.
“The constant theme for most countries is positive,” says El-Erian. “ But there is no uniformity among countries. On the undervalued side are Brazil and Russia, on the overvalued side are Venezuela and Uruguay, where there are issues with fiscal and monetary policies.“
Another uncertainty facing emerging markets investors is the state of the global economy, in particular of the US and Chinese economies. China is the most dynamic emerging market with growth rates between 8 % and 9 % over the last four years. There are fears, though, that this could all fall apart as the economy overheats and experiences a hard landing. The Chinese central bank’s recent interest rate hike of 0.25% shows that the Chinese government harbours similar worries.
Any slowdown in Chinese growth rates would hit commodity prices, on which many emerging markets depend. Some analysts have pointed to the sharp decline in metal prices in mid-October as an indicator for such a development. Most investors, however, are sanguine on China. “A massive contraction in China would be felt in our world,” admits Gahler. “But we assume that China continues to grow.”
Jerome Booth, head of research at Ashmore Investment Management, argues that the dire effect of a slump in China on the world economy would benefit other emerging markets. “Emerging markets are the big beneficiaries of slower growth. If growth slows, it makes institutional investors less attracted to the US and increases the rationale for doing something else,” he says.
Even if the emerging markets were to be hit by an external shock, the asset class is a lot sturdier than it was five or so years ago. Much of this is down to the growing interest of institutional investors, such as portfolio managers, mutual funds and insurance companies.
According to the Institute of International Finance, emerging markets have seen an increase of capital inflows from long-term fund managers over the past three years. Overall, portfolio investment in emerging markets debt is expected to jump to $55.5 billion this year from just over $15 billion in 2002.
Partly, this trend can be explained by low US treasury rates that have forced investors to seek higher yields to diversify their portfolios. “Pension funds have massive problems meeting their unfunded liabilities,” says Booth.
The unprecedented involvement of big funds represents a significant change for the asset class’s fortune. “The typical investor today is different to three or four years ago,” says Gahler. “Pension funds are long-term holders. There has been a structural change in who holds the debt.“
A potentially very different change has been in the influence of hedge funds. According to JP Morgan, hedge fund activity in emerging markets has doubled over the past two years and accounts for nearly 40% of the bank’s emerging market debt trading volume in 2004. However, hedge fund activity – which tends to move money quickly in and out of countries leading to price volatility – is more influential today in the secondary markets.
The new issue market, is instead, dominated by the big institutional players. “Together with Pimco, which pursues a similar strategy, we command $20 billion,” says Booth. “Hedge funds can’t compete against us. When we buy, the bear market is over.”
Other investors are more cautious. “Hedge funds borrow cheaply in the US to invest it in emerging markets. If US interest rates go up, people will sell emerging market assets,” argues El-Erian. “[Hedge funds] are a potential source of global instability, but also add liquidity to the market.”
If an external crisis does arise, these funds may well withdraw leading to volatility. However, practitioners are confident that the asset class will recover quickly. “You could see a 25% stock market crash on Wall Street and we would be fully recovered in four months,” says Booth. “It’s not a risky asset class, it’s just the opposite, and it is likely that institutional investors reduce the risks.”