By Ivailo Vesselinov
There is no doubt that EM debt stands out in a world of “the new normal”, where developed market policy rates and yields are mired in negative or ultra-low territory as far as the eye can see. The attractive yields and ample diversification opportunities on offer across the EM universe simply cannot be ignored. Moreover, the EM asset class has delivered generous returns consistently over the full economic cycle, although it is worth highlighting that EM equities, which are most commonly associated with the “EM story”, have underperformed significantly over this period.
Adding to the favourable mix, robust EM macro fundamentals and cheaper valuations have now come into sharper focus for investors. For example, the positive EM-DM growth differential, which historically has been the most important driver of capital inflows to EM, is set to widen again from this year.
Nevertheless, despite the attractive yields and history of outperformance, investors remain structurally underinvested in the asset class, implying plenty of room for rebalancing in the years ahead.
Given high yields and historical returns, improving growth prospects, structurally clean technicals and more attractive valuations, why have investors remained slow to embrace the opportunities on offer in EM? We believe that part of the reason lies in legacy concerns that fail to recognise how EM has evolved from times of past crises, meaning that a lot of the conventional wisdom on EM is now outdated and potentially misleading.
One popular misconception recently has been the fear of an endless capital exodus from EM, in the face of monetary policy normalisation in DM. Whilst there is no denying that some money has left EM since the infamous Fed QE taper speech in May 2013, this natural adjustment was never going to be infinite. In early 2016, retail bond flows into EM fell below their pre-QE trend level, which we highlighted as a sign that whatever Fed-fuelled excess liquidity had entered the market in temporary search for yield had now exited, leaving far cleaner technicals.
It is also important to note that, whilst retail bond flows were busy coming in and out of the asset class, institutional bond flows (which are more stable and long-term in nature) have enjoyed an uninterrupted steady increase over the past decade. And to put all of this into perspective, bonds represent only 11% of total capital inflows into EM (vs. 48% for FDI, for example), which means overall capital flows to EM have been far more diverse and resilient than investors have been led to believe.
Another widespread and often misplaced concern about EM debt has been the role of China’s economic slowdown and its impact on growth prospects elsewhere. Some of the scariest headlines about China in recent years have alluded to the surge in domestic credit as a share of GDP, and the rapid decline of official FX reserves. However, what often goes unmentioned is that China’s overall debt levels remain below those of many of its regional peers, such as Malaysia, Hong Kong, and Singapore, or that much of the recent capital outflow has gone on repaying short-term external debt, which is a finite and self-limiting process.
Moreover, capital outflow is exactly what should be expected for an economy in China’s position, which still has infinitesimal foreign portfolio assets and accounts for only 10% of global bond and 12% of global equity markets, despite its far larger economic share. We reiterate our long-held impression from our own interactions with Chinese policymakers and investors that Beijing remains on top of the economic challenges it is facing and has both the ability and the willingness to resolve them. China should therefore be seen a source of opportunity, not just risk, for the rest of EM.
A further common misconception has been the belief that EM economies can be conveniently lumped together into catchy acronyms, such as BRICs or MINTs, or invested in on the basis of whether they happen to be commodity exporters or importers. However, there is now more that seems to differentiate the BRIC economies from one another than to unite them. As has transpired over time, it is a combination of several complex factors that determine the characteristics of individual economies, and they lead to much less homogenous outcomes than once thought.
Despite these misconceptions, there are, however, legitimate risks for the asset class, which are often overlooked. Such risks may include an unexpected re-emergence of inflationary pressures, and loss of competitiveness of EM exporters against their DM counterparts.
Against this backdrop, we assert that capturing the attractive investment opportunities in EM will increasingly require new thinking and deep dives on individual macroeconomic fundamentals, rather than one-size-fits-all analysis. We believe that countries that are able to embrace a prudent mix of monetary and fiscal policies, coupled with structural reforms aimed at strengthening domestic institutions and the business environment, and the generation of new growth models that are less dependent on trade, are set to outperform in the months and quarters ahead.
Ivailo Vesselinov is chief strategist at Finisterre Capital
