By Uday Patnaik
It is well known that a significant number of bonds in developed markets are trading at negative yields – a result of low interest rates and global quantitative easing policies.
Weak developed market growth argues for low bond yields, but policymakers are becoming more aggressive in their quest to boost inflation, with helicopter money now in focus. Risks are therefore more balanced around very low developed market government bond yields.
There are also many macro risks within developed markets that could induce credit volatility. Political flashpoints include ongoing rhetoric around Brexit and the recent result of the US presidential election. Meanwhile, key European elections are approaching – in Germany, Italy and France – which could bring the immigrant crisis back into focus.
Beyond the political noise, developed market growth remains sluggish, and there are ongoing concerns over the solvency of a number of European banks.
Rating agencies have reacted by downgrading developed countries in recent years, which has seen the ratings of emerging and developed countries gradually converge.
EMs: Not one homogenous investment
It is not that emerging markets do not have similar risks – they certainly do. But what were once seen as difficult political and economic investments now feel more familiar to developed market investors.
Credit spreads have been volatile in recent years, and investors who have blindly bought emerging market assets have lived with numerous ups and downs. For example, with commodity prices falling dramatically since the middle of 2014, we have seen a number of significant problems across commodity-exporting countries. More recently, however, there are signs that economies such as Brazil and Russia are gradually finding their feet.
But correlations between different emerging market countries and regions are lower than they were at the genesis of the asset class. Emerging markets are no longer seen as one homogenous investment.
There is now considerable diversity of opportunity in emerging markets compared to developed markets, with wide differences in ratings and spreads between countries. The emerging market debt (EMD) universe is vast, covering both corporates and sovereigns, together with a choice between local and hard currencies.
This backdrop is ideal for active investors, who are best places to sift through the winners and losers of a highly diverse opportunity set.
Diversity of opportunity
We see a number of opportunities, as well as key risks to avoid.
While Latin America faces structural difficulties, Brazil and Argentina are in the process of exiting a politically-driven economic downturn. Meanwhile, Colombia is at last going through a peace process after decades of civil conflict.
On the other hand, we are cautious on Asia and The Middle East. The latter still faces a challenging environment of fragile oil prices coupled with fixed exchange rate pegs that remain vulnerable. Our Asia outlook is dominated by China, which we believe faces a very difficult balancing act to moderate debt without impacting growth.
Just as the result of the US election has brought heightened volatility to an otherwise relatively benign Mexican investment story, so too has Central and Eastern European (CEE) sentiment been damaged by the uncertain implications of Brexit and the political shake-up within the EU. Nonetheless, we see some value in corporates that face a stronger technical backdrop and company deleveraging, helping them deal with the challenges of geopolitics and terms of trade deterioration.
Not to be Trumped
The US election outcome is one of the many developed market geopolitical outlier events that emerging market assets will have to contend with in the coming years. Emerging market economies will potentially face negative spill-over effects from US protectionism, as well as a reflation story that is driven by tax reforms and an expansive fiscal policy.
A resulting stronger US dollar versus emerging market currencies strengthens the case for exposure to hard currency EMD, rather than local currency bonds. We also see more relative value in sovereign issuers with less export exposure to the US and corporates with lower leverage and USD liabilities.
As investors become more familiar with the long-term opportunities and risks surrounding EMs, we expect more money to find its way into an area of the world that has historically been underinvested in.
Uday Patnaik is head of emerging market debt at Legal & General Investment Management
