By Yacov Arnopolin
Flows in any investment market are driven by two things: its own characteristics and those of the alternatives open to investors.
That comparative analysis lies at the heart of all investment decisions and asset classes with desirable features of their own – without the drawbacks associated with other options – are naturally most favoured by investors.
We believe that this is what is happening with Emerging Markets. Thanks to the constant downward pressure in yields seen in Developed Markets and the sustainable value evident in Emerging Markets, there is a clear investment case for the latter.
The broader context is key to this. We have noted several times that there are nearly $7 trillion of Developed Markets bonds with negative rates. Coupled with a reduction in new issuance supply, this creates a clear bid for yield.
Recent dovish statements from the Fed suggest that US monetary policy is unlikely to provide much relief for yield-hungry investors: at the March meeting Fed Chair Janet Yellen noted the risks posed by global economic and financial developments and appeared tolerant of rising inflation, which put immediate downward pressure on US Treasury Yields.
The scale of the yield problem is striking. 24% and 34% of securities respectively in the JP Morgan global and Eurozone government bond indices (which track DM) have negative yields. For Developed Markets bonds that do offer attractive yields, these are likely to be depressed if large numbers of active investors add them to their portfolios.
This is not the case in Emerging Markets. Taking the indices as a guide, even the high-quality investment grade components of the market offer yields well above 4% and investors willing to take more risk can expect yields above 6%. This dynamic, between low-yielding Developed Markets and high-yielding Emerging Markets, will provide a push factor into the latter, much as we saw during the early stages of the Quantitative Easing era.
In Europe, policy decisions are exacerbating the declining availability of yield. In March, the European Central Bank announced its Corporate Sector Purchase Programme (CSPP), which extends its monetary easing strategy to the purchase of corporate bonds.This will inevitably have a major impact on the availability of assets given the experience of other markets to have come into the ECB’s sights: it purchases around a third of all newly issued covered bonds, for example.
Faced with competition from the ECB in the investment grade corporate market, private investors are likely to move down the credit scale, depressing spreads in the process. Indeed, the Central Bank itself could be directly responsible for a move in this direction: as a single BBB rating is sufficient for investment grade qualification, split-rated bonds could form part of its corporate purchases.
Spreads on Emerging Market bonds, insulated from the technical effect of official-sector purchases, reflect fundamentals rather than the distorting influence of easing policy. Indeed, we believe that they indicate a more bearish scenario than is likely.
We do not, of course, deny that the sector has its challenges. Most emerging economies have still not found an alternative to the commodities-driven export model; China faces a painful slowdown; and corruption, political military adventurism and power consolidation by the executive are not unknown in key constituents of the sector.
But while Emerging Markets countries are vulnerable to numerous problems, these nations are not about to default, cease to exist or collapse simply because their currencies are losing ground and they make good fodder for negative stories in the press. Indeed, looking at the correction in credit markets since the beginning of the year, Emerging and Developed Markets have adjusted by very similar margins – contradicting the notion that the former will always be more volatile.
In the context of a dovish Fed, negative rates in Europe and Japan and spread compression incorporates due to the ECB’s purchases, we believe that Emerging Market sovereign/corporate debt is one of the few remaining bastions of decent credit quality and yield.
This won’t go unnoticed for long. The flows are coming.
Yacov Arnopolin is managing director and portfolio manager, emerging market debt, at Goldman Sachs Asset Management
