Emerging markets: two steps forward, one step back?
With yields across much of the developed world entrapped in an apparently endless downward spiral, investor attention is once again focusing on the potential of emerging market (EM) debt. Cristian Maggio, global head of emerging markets strategy at TD Securities, explains that it is not just the relatively high yields available in the asset class that is attracting renewed investor interest. Following a lengthy period of underperformance, there are several compelling drivers of rising investor confidence in the longer term prospects for EM.
A more benign external environment for EM debt
The first of these is that external conditions no longer look as threatening for the EM asset class as they did as recently as January. Then, conventional wisdom assumed that EM debt was vulnerable to the toxic combination of weak commodity prices and an imminent slowdown in China.
The asset class was also considered at risk from an expected rise in US interest rates, which was seen as being potentially most damaging for those emerging economies with high levels of US dollar-denominated debt. With a US rate rise now looking unlikely before September, and with the upward trajectory of US rates expected to be gentler and more predictable than previously assumed, EM debt is now believed to be less sensitive to US monetary policy than many investors feared in 2015.
Investors also appear to be more relaxed about a second perceived external threat to EM debt, which has been anxiety over the impact of a so-called hard landing in China. “To some extent, this has already been priced in,” says Maggio. “Our analysis suggests that China is growing at 4% or 5%, which would have been seen as a hard landing under the old paradigm. Now, there is a growing recognition that China’s economy is in a transitional phase, and as long as the transition is not disorderly, there is no reason to believe this will be a trigger for a global meltdown.”
Maggio adds that while external factors are now looking more benign for EM debt, so too are the demographic and structural dynamics that are gathering momentum in many emerging economies. “Many emerging markets remain stories of under-development,” he says. “We assume that the process of convergence with developed markets will generate higher average rates of economic growth together with falling inflation and declining interest rates in emerging markets.”
None of this is to imply that the outlook for EM debt is uniformly positive. “This will not be a linear process and there will inevitably be corrections in currencies and government bond curves,” Maggio says. “But given our constructive long-term view of the asset class, these setbacks may be a good time for investors to enter the market or add to their exposure.”
Maggio recognises that the EM debt asset class is highly heterogeneous, with the individual markets and regions within the EM universe confronted with very different economic, demographic and political challenges and opportunities. While this may provide highly profitable opportunities for alpha-seeking investors with specialist local knowledge, others may prefer to minimise risks by opting for the diversification that an index-based approach provides.
Another way of mitigating the risk associated with EM debt exposure, says Maggio, is through exposure to the increasingly liquid and well-diversified market for the local currency-denominated debt of top-rated supranational borrowers. Buying into local currency issuance of triple-A rated issuers such as the IBRD, IFC or IADB, says Maggio, strips out the credit risk of investing in EM while retaining exposure to the main driver of performance, which is the currency. This need not mean compromising on liquidity. Maggio points out that the Mexican peso, for example, is now the fifth most actively traded currency in the world.
A GDP-weighted portfolio approach
TD Securities has been taking the strategy of EM exposure via SSA issuers a step further by developing a model portfolio weighted by the GDP of the world’s 40 largest economies. To ensure that the portfolio is not dominated by the four global giants of the US, the eurozone, China and Japan, the exposure to each individual economy is capped at between 10% and 15% of the total. “A GDP-weighted portfolio offers investors exposure to a much more efficient reflection of the structure of the global economy than traditional indices,” Maggio explains. “A benchmark based on market capitalisation essentially means that the more debt a country has, the more representation it has in the index. This may make sense from a liquidity perspective but is irrational because it fails to reflect long-term economic dynamics.”
Feedback from investors, says Maggio, has been positive. “For investors in markets where interest rates are at or near zero, a GDP-weighted portfolio offering an annualised yield of 4%-5% with a triple-A product behind it is very appealing,” he says. “It exposes investors to currency risk, but for those able to manage FX volatility over time, this could be the perfect product for generating alpha.”
The TD Securities Global EM Conference
This innovative approach to EM investment, twinned with the longer-term prospects for the asset class, will be among the topics to be discussed at TD Securities Global EM Conference in Milan in September. A one-day event bringing together highly-respected speakers from politics, finance and academia across the EM universe. A unique opportunity to exchange views in a series of roundtable discussions.