A truly active approach to equities based on fundamental research and a disciplined investment process
Emerging market debt is one of the largest, most liquid asset classes in the world. It has an estimated market capitalisation of $11.6 trillion, of which sovereign bonds issued in local currencies account for 72%.*
The JP Morgan GBI Emerging Market Global Diversified Index, which tracks local currency sovereign bonds across 19 developing nations, has an average yield to maturity of 6.1%. That’s comfortably higher than the comparative yield of developed market equivalents.
At the same time, the average credit rating of instruments in the index is BBB. It makes emerging market debt the only mainstream asset class to offer investors both strong relative yield and investment grade credit quality.
The fundamentals of emerging market economies have improved strongly over the past 30 years.
The fundamentals of emerging market economies have improved strongly over the past 30 years. In many cases, authorities have tightened regulatory and financial controls and adopted orthodox monetary policies allied to fiscal reform. They benefit from a growing middle class.
By contrast, authorities in advanced economies have spent much of the past decade propping up their markets with monetary and fiscal stimuli that have added enormously to their debt burdens. This will drag on future growth. These markets are suffering from weakening demographics.
It is in emerging markets that investors will find growth. The International Monetary Fund has forecast that developing economies will increase their share of global gross domestic product based on purchasing power parity to 63% by 2023.
Emerging market bond issuers have delivered consistently lower default rates than developed market peers. In fact, analysis of historic returns** reveals local currency emerging market bonds have delivered an average volatility of 7.3%, versus 12.8% for equities.
But despite a healthy yield spread over US Treasuries and low default risk, emerging market bonds remain grossly under-represented in investor portfolios. The average allocation is 5%*** – even though the asset class accounts for 25% of all outstanding debt globally.
Stabilising economies have enabled emerging markets to issue bonds in local currencies increasingly. This can help to reduce exposure to external shocks. When the MSCI World Index sank more than -50% in the 16 months to February 2009, emerging market bonds returned almost 19%.**
We do not hedge currency exposures. This is a key aspect of the risk premium we are looking to capture. However, we don’t want a large underweight to the base currency of the fund by default. Therefore we put on currency forwards so this position is effectively funded from a basket of six developed market currencies (AUD, NZD, CAD, NOK, SEK, GBP) largely selected to reflect their sensitivities to economic conditions, commodity prices and debt vulnerabilities.
This has the effect of smoothing out returns and enhancing the diversification benefits of the asset class without materially affecting our expected returns.
One impact of quantitative easing in developed markets in response to the 2008 global financial crisis was that it inflated bubbles in asset prices that will burst sooner or later. But as a multi-asset investor, we look to diversify, including exposure to assets as little correlated to developed markets as possible.
The JP Morgan GBI Emerging Market Global Diversified Index features 19 issuing countries across emerging markets, offering a wide range of opportunities to diversify by region, interest rate and currency exposure.
Last year was a challenging one for emerging economies. There were a number of headwinds to contend with, including US rate hikes, a strong US dollar, slowing global growth expectations and country-specific challenges for Turkey, Argentina, Russia and South Africa.
In spite of this, the JP Morgan GBI Emerging Market Global Diversified Index produced a return of -1.3% for the year and positive return in the fourth quarter of 2018 when equity markets sank precipitously. Again it underlined the resilience and independence of the asset class.
US Fed chairman Jay Powell has since commented that the next move in rates is as likely to be down as up. It suggests that normalisation in Fed monetary policy is largely complete for now. This apparent pivot in Fed policy should be supportive for emerging markets.
The slowdown in US growth means the yield differential with emerging markets should start to grow. If the Fed has finished hiking, then a number of emerging market central banks will be in a position to cut rates, which enhances value for bondholders.
As inflation falls, so policymakers can reduce interest rates to spur economic growth. It is something we expect to see in the likes of Mexico, Indonesia and the Philippines.
Of course, investors remain nervous about currency risk, even though emerging market currencies are undervalued in historic terms. But there are reasons to think the US dollar will remain stable this year.
Typically a widening growth differential between emerging and advanced economies is a bullish signal for emerging market currencies. The developing markets that were under pressure last year, such as Argentina and Turkey, are under pressure again this year.
But the strong carry that emerging markets offer mean that investors don’t necessarily have to rely on strengthening emerging market currencies to make healthy returns. The Argentine peso may depreciate, for example, but total return in peso bonds will be offset by the carry investors can earn.
* JP Morgan, 31 December 2018
** This analysis (and all other mentions of returns in this document) uses monthly returns for the JP Morgan GBI EM Global Diversified index against our funding basket from the inception of the index on 31/12/2002 to 30/6/18. For equities we use the MSCI World Index (hedged to GBP) over the same period.
*** Mercer European Asset Allocation Reports, 2013-17; JP Morgan
**** JP Morgan, 29 December, 2017