By Salman Ahmed
With traditional risk premia subdued and interest rates in advanced economies at historical lows, investors are being forced to look elsewhere to generate returns. In our view, emerging market debt (EMD) in local currency offers an attractive opportunity on the back of both fundamentals and valuations.
However, we think investors need to rethink implementation when it comes to accessing EMD given the underlying shift in the paradigm of fixed income markets.
Central bank dominance and tightening regulations mean today’s new world is characterised by fractured liquidity, and in the case of EMD, increasing concentration in the same few positions or herding. Together, these two factors leave investors heavily exposed to growing liquidity and market risk.
We believe investors need to reassess their starting point. The EMD market is dominated by market-cap based benchmarks which reward leverage. Investors should consider low-turnover strategies and make them effective by using a quality-driven portfolio construction process which aims to mitigate default risk.
Why invest in EMD?
The case for EMD and an investor’s risk/reward assessment should come down to three key aspects: fundamentals, valuations and risk.
In fundamental terms, the case for emerging markets (EM) is starting to look positive. Although many EM economies struggled between 2011 and 2015, the authorities’ policy response, which favoured weaker currencies, is starting to be reflected in improved external profiles.
The pace of economic growth in a number of EMs has begun to rise again, outpacing that of highly indebted advanced economies by a margin, which historically has been a key state variable consistent with sustained EM asset outperformance.
The severe compression in interest rates in advanced economies in the last six months has pushed EM yield differentials to around 5.2% p.a. vs the US and nearly 7% p.a. vs Germany. These are sizeable given the widespread incidence of low/negative yields in a number of developed countries.
There are of course risks associated with emerging economies, not least the chance of a sharp China-led financial meltdown and higher interest rates in the US. However, we expect Chinese data to improve in the coming quarters, as the impact of policy loosening has yet to be fully realised. Structurally, the authorities also appear willing to use foreign exchange reserves to backstop the system. In addition, China is a net creditor to the world, which also reduces some of the key tail risks emanating from the high amount of leverage in the domestic economy.
Meanwhile in the US, the Fed’s cautious hiking no longer points to an ever-increasing US dollar, in our view. We think real interest rate differentials and rising global risk factors will continue to limit the Fed’s ability to hike on a sustained basis despite the recent pick-up in the pace of labour market activity. That said, investing in these markets is far from straightforward, especially, given the high incidence of idiosyncratic risk.
The traditional approach is broken
The majority of EM investors take a market-capitalisation approach to their portfolios, but this has considerable drawbacks. One of the most pronounced flaws is the inherent nature of market-cap indexes in fixed income to reward the most indebted issuers, regardless of their capacity to service that debt.
Another is that investors are exposed to increasing market risk, as herding around benchmarks increases the concentration of assets in the same securities. Faced with difficult trading conditions caused by fractured liquidity, the opportunity to generate outperformance through a high-turnover active approach is eroded, which reduces the ability of active managers to provide consistent value-add.
Focus on quality with low turnover
Where both underlying economic differentials are becoming wider and the ability to exit positions in a friction-less manner is becoming harder, a focus on quality becomes critical. Rather than following the traditional approach, investors should instead focus on the underlying fundamentals of issuers, assessing each country on its own merits rather than its capacity to borrow, thereby bringing quality to the heart of portfolio construction.
We believe this fundamental-driven approach is well-suited to a “trade less” framework because it is rebalanced semi-annually. The result is similar turnover (53%) to a passive market-cap replication (45%), which is considerably lower than many other active approaches but with a sounder, transparent and more resilient investment approach. A fundamental-driven approach has delivered higher risk-adjusted returns over the last six years, and tends to be more resilient in down markets.
We believe there is a strong case for investing in EMD given changing fundamentals and valuations against a backdrop of very low yields in advanced economies. However, fractured liquidity, rise in market risks and increased differentiation within the EM space imply the traditional approach is not suitable for dealing with the current challenges. In our view, investors need to rethink their approach to bring quality to the heart of the portfolio construction process through a low-turnover, fundamentals-based approach.
Salman Ahmed is chief investment strategist at Lombard Odier.
