The graph above highlights how the macro-fundamentals of different emerging markets are diverging markedly. More importantly for bond investors, markets are starting to take notice as fundamental risk is better rewarded and priced accordingly.
Between 2003 and 2007, the dispersion of public debt ratios in emerging markets narrowed. Since then, they have begun to diverge again. Similarly a sharp convergence in emerging markets inflation rates started to give way to greater differences across countries. While the picture for economic growth is less-pronounced, the data still confirms that divergence of emerging market countries’ growth is now above the lows seen in 2011 and significantly higher than the 2005/6 lows, says Lombard Odier Investment Managers (LOIM).
The economic signals used to assess emerging markets are increasingly different depending on the characteristics of each economy. There is growing evidence that bond markets are spotting this and therefore bond investors who adopt a fundamental approach should be well positioned to benefit from this trend, according to LOIM.
Changes to inflation over the 2013-2014 period for a given developing country are strongly associated with the performance of the country’s bond market (in USD terms). Countries such as Hungary, India, China and Thailand for example, which delivered a positive return to bondholders over the period, also saw a strong decline in their inflationary dynamics.
On the other hand Russia, by far the weakest performer for bond investors, saw a rise of 2.4 percentage points in inflation over the period. Overall the return for bondholders from countries which experienced a fall in inflation over the period was +2.6%, compared with -13.3% for those emerging market countries which saw a rise in inflation.
Bond investors should expect fundamental differentiation to remain a more permanent feature of the global landscape, LOIM believes. Investors who apply a market capitalisation approach, which directly rewards the most leveraged borrowers, miss out on quality fundamentals that help to identify where to look for the best relationship between long-term risk and reward.
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