- In the decade since we launched our Emerging Markets Local Currency Bond Strategy, the asset class has evolved at what at times has seemed like a breathtaking pace.
- Our experiences over that time have confirmed our view that the most effective way to invest in emerging markets (EM) local debt is through active management, for three main reasons: (1) to take advantage of non-benchmark opportunities, (2) to benefit from differences in interest rate cycles between countries, and (3) to reduce currency risk.
- We believe the factors that have given active management an edge over passive approaches to EM debt over the past decade will persist for the foreseeable future.
- Growth dispersion between emerging markets countries looks set to continue, while inflation divergence between nations at different cyclical stages is also likely to remain. As long as this differentiation between EM countries is maintained, opportunities will continue to arise, providing active managers with greater flexibility to generate stronger returns.
In the decade since we launched our Emerging Markets Local Currency Bond Strategy, the asset class has expanded and matured at what at times has seemed like a breathtaking pace. As emerging markets have grown in size, the borrowing needs of EM countries have increased accordingly, creating debt markets of increasing depth, breadth, and liquidity. These developments have brought with them challenges as well as opportunities, and the EM local debt market has seen considerable churn as a number of early participants have fallen by the wayside. For those that remain, however, the opportunity set looks more exciting than ever.
The EM local debt market now accounts for around 80% of newly issued EM debt—and some 66% of all outstanding EM debt excluding China and India. Index yields have averaged an attractive 6.75% over the past decade, and over the past seven years have offered a remarkably steady 6%–7%—comfortably above that of developed markets. At the same time, the investor base has evolved as increasing numbers of foreign participants have joined local investors as purchasers of EM local debt. This broader mix of investors has helped to create a better overall understanding of the asset class, which is no longer regarded as a niche area accessible to only a handful of specialists. Today, there are 18 countries represented in the J.P. Morgan GBI-EM Broad Index compared with 13 countries 10 years ago.
Figure 1: Outstanding EM Debt
As of December 31, 2016
Sources: J.P. Morgan and T. Rowe Price.
As the EM debt market has evolved, emerging markets more broadly have undergone profound social, political, and economic change. Progress has not been uniform, however. While some emerging market countries have embarked on significant reform programs and made notable advances in macroeconomic policymaking, others have not. Fluctuations in commodity prices have also been a key determinant to the underlying performance of individual countries. Over the past 10 years, the leading performers in the asset class have been Indonesia, Peru, and Brazil, while the laggards have included Turkey and Russia.
ACTIVE MANAGEMENT KEY TO NAVIGATING MARKET
Our experiences over the past decade have confirmed our philosophy that the most effective way to invest in EM local debt is through active management. There are a number of reasons for this. First, there is less information available on emerging markets than on their developed world equivalents and far more unknowns, meaning that assets have more notable pricing inefficiencies, providing scope for alpha generation. This frequently creates deep pockets of opportunity for active investors who are able to reposition their portfolios accordingly—however, these will not typically be accessible to investors in passive EM portfolios.
Since we established the Emerging Markets Local Currency Bond Strategy, we have, for example, taken off-benchmark positions in countries such as India and Serbia—higher-yielding, lowly correlated markets with strong risk/return profiles—that would be unavailable to investors in EM indices. In addition, as active managers, we also have been able to invest in countries such as Romania and Argentina before they’ve joined the benchmark, enabling us to gain access to certain markets—and at attractive valuations—ahead of passive investors. On the other side of the coin, we also have been able to exit markets before they’ve been excluded from the benchmark, such as Slovakia in 2012 and Nigeria in 2015.
Second, active managers can exploit the difference in interest rate cycles between countries to add value. Economies where interest rates are declining or are about to decline will typically offer greater opportunities for capital appreciation than those where interest rates are stable or rising. In recent years, this has been a particularly notable driver of performance, with interest rate cycles diverging hugely across the EM universe. Between the end of 2012 and 2015, Polish local yields halved (to approximately 2%) while Brazilian yields doubled (peaking at 16%). Then in 2016, our positive stance on parts of Eastern Europe (for example, Romania) and Asia (notably, Indonesia and India) was supported by the easing of monetary conditions. Meanwhile, a more defensive stance in Mexico, which continued to see a divergent tightening cycle, was supportive. Passively managed portfolios are less able to capture these differences.
A third advantage of an active approach to EM local debt is the potential reduction of currency risk. While coupons have delivered most of the EM returns over the past decade, currency exposure has provided the major source of investment risk (see Figure 2). Actively managing currencies can reduce volatility, improving the quality of active risk being taken, and can help to avoid large downdrafts in performance, particularly in times of U.S. dollar strength. For example, our decision to be underinvested in the Turkish lira in the last three months of 2016 helped performance as the currency depreciated steeply amid concerns over Turkey’s volatile political and economic environment; a negative stance on the South African rand during its sharp weakening in 2015 proved similarly beneficial. Passively managed portfolios are generally more exposed to sharp currency sell-offs.
Figure 2: Currency Impact on EM Local Debt Returns, 2007–2017
As of March 31, 2017
Past performance is not a reliable indicator of future performance.
Source: J.P. Morgan Chase & Co.
DISPERSION OF PERFORMANCE SET TO CONTINUE
We believe the factors that have given active management an edge over passive approaches to EM debt over the past decade will persist for the foreseeable future. Growth dispersion between emerging market countries looks set to continue as reforms are implemented to different degrees and at varying speeds, while inflation divergence between nations at different cyclical stages is also likely to remain. As long as the differentiation between EM countries is maintained, opportunities will continue to surface, providing active managers with greater flexibility to generate stronger returns by tilting their portfolios accordingly.
The challenges associated with investing in local EM debt markets—less information, greater political uncertainty, increased currency risk, etc.—are also likely to persist. We believe that, here, active managers have an advantage over passive investors due to the former’s ability to minimize exposure to higher-risk countries with the potential to inflict downside losses. Current risks include growing geopolitical tensions—in particular, issues related to North Korea, uncertainty over the growth trajectory of China, and the looming prospect of an end to the long era of ultra-accommodative monetary policy on the part of developed market central banks, most notably the Federal Reserve.
Of these, the latter is causing particular concern. This is hardly surprising: During the “taper tantrum” of 2013, the mere suggestion that the U.S. Federal Reserve might slow its pace of asset purchases wreaked havoc in emerging markets as investors fled the marketplace. There are fears that something similar may occur again as the Fed and other central banks finally begin retreating from monetary stimulus.
STRONGER FUNDAMENTALS BUILDING RESILIENCE
However, while the withdrawal of easing measures is likely to cause bouts of risk aversion, leading to periods of volatility across all asset classes, we do not believe that it will have a significant long-term negative impact on emerging markets. The Fed has been very clear about its intention to begin running off its balance sheet, so investors should have already factored in any impact on asset prices. In addition, the backdrop this time around is much more favorable than it was in 2013: Global growth is more balanced, valuations in EM are better, and the external balance sheets of EM countries have improved quite notably over recent years. In addition, participation in the local debt markets is much less stretched than it was in 2013, with more attractive yields versus developed markets. All this means that the EM local debt market is in much better shape to withstand any reduction in flows from developed countries than it was four years ago.
Moreover, although developed market yields are set to rise over the next few years, EM local debt will continue to offer relatively attractive yields over the long term. In a world where global bond yields are historically very low and the maturity of sizable outstanding developed market debt is relatively long, EM local debt, with its notably higher yield and lower-maturity characteristics, remains attractive. On the foreign exchange side, the scale of the current U.S. dollar rally, which has now lasted for more than five years, suggests that the dollar strengthening cycle is maturing, with valuations supporting emerging market currency strength in the medium term. Currencies of countries that are experiencing external rebalancing are especially likely to appreciate in this environment.
Overall, the long-term fundamentals of emerging markets remain strong relative to their developed market peers and local debt markets in particular offer a very compelling way to gain exposure to them. At the same time, persistent dispersion between EM countries means that an active management approach is likely to continue to offer clear advantages over passive strategies. Through our actively managed strategy, with our relentless focus on identifying countries with the most promising fundamentals, technical factors, and valuations, we believe the next 10 years offer even better opportunities than those seen over the past decade.
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