Understanding the key to development

December, 2012 Print

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Peter Marber

Chief Business Strategist,

Emerging Markets Debt & Currencies,

HSBC Global Asset Management.

 Peter marber of hsbc global asset management looks at some of the key issues which may be holding schemes back from investing in emerging market debt.
 

Emerging markets have come a long way from the financial crises of the 1990s, which largely stemmed from having currencies pegged to the US dollar. The abandonment of these currency pegs allowed many of these countries to accumulate substantial foreign currency reserves. Their strong position saw them through the 2008 financial crisis in much better shape than many developed markets.

 Although it is now widely acknowledged that the engine of global growth has switched to the emerging markets, most UK pension schemes remain predominantly exposed to developed markets. Many schemes have had allocations to emerging market equities for some time, but remain heavily invested in developed market assets through their bond portfolios. We believe that an allocation to emerging market debt should be considered for a range of schemes, and look at some of the questions we are commonly asked about emerging market debt (EMD).

 1. What are the key reasons to consider EMD in a long term investment portfolio?

 Two key reasons: returns and diversification. A portfolio of EMD – when we include hard currency and local currency – can potentially offer returns considerably higher than and with lower correlation to developed market fixed income indices. Since 2000, EMD has on average returned 4% more per annum than government bonds1, and, we believe, future prospects look encouraging given the current low yields today. Over time, as emerging economies improve, we should see credit spreads tighten and currencies appreciate. In addition, if we blend EMD with developed market assets, we should see a decrease in total portfolio volatility, depending on the mix.

 2. Why do you think people have been reluctant to move in to EMD?

 Again, there are two reasons: the “home bias” and the odd phenomenon of EMD indices, which mix investment grade and high yield assets. Firstly, investors have a natural aversion to globalising their portfolios, or what analysts call the “home bias”. The emerging markets of Asia, Latin America, the former Soviet Union and Africa are often perceived as risky as a result of their assorted crises in the 1990s. When we think about diversifying away from home markets, investors tend to add from the largest, developed markets first (the US, Europe, and Japan). Secondly, EMD is a mix of investment grade and high yield countries, which makes it a tough asset class to classify. The amount of bond money that can be invested in non-investment grade assets is quite limited; this feature has most likely kept money out of the market and not allowed the asset class to develop properly.

 3. Why have a specialist EMD investment manager as opposed to including EMD within a global bond manager allocation?

 Peer group data suggests that even median managers in EMD tend to outperform their indices by a wide margin. Also, EMD is now a large enough asset class that investors should, where appropriate, consider it as a structural, core asset in their bond mix, not just an opportunistic trade.

 4. We have exposure to emerging market equities in our portfolio. Why do you think that investing in a country’s debt is a better way to access exposure to its growth?

 Equity performance, surprisingly, is not that highly correlated with GDP growth; this is a major misconception by investors. Equity markets are not always highly linked to developing economies, as many of the most important companies are often stateowned or privately-held enterprises.

 However, if a country is growing fast with inflation under control, there is a high probability of credit spread compression and appreciating currencies, and this favours debt, not necessarily equities.

 5. We are considering a passive EMD solution, why do you think an active solution is potentially a superior option?

 As mentioned earlier, even median EMD managers have tended to provide considerable outperformance versus indices. It is a less efficient asset class that typically favours active managers.

 Passive strategies tend to work best in highly efficient, low alpha asset classes. But EMD remains a less efficient arena.

 

 

 6. This seems to be a “hot” asset class at the moment; do you think there will be problems with liquidity in EMD Markets in the future? We don’t think it’s a “hot” asset class.

 Many EMD credit spreads are still wider than they were five years ago even though credit fundamentals have improved dramatically during this period there have been over 100 credit upgrades in EMD markets since 2008.

 And currencies, too, are still theoretically cheap relative to Purchase-Power-Parity. If the market was “hot” EMD valuations would be expensive, but on average, we believe they still appear cheap.

 7. Why are these countries called “Emerging”, when many of them have better credit ratings than so called “developed” markets?

 The term “emerging” was coined over 20 years ago, and it unfortunately doesn’t do the space justice. To many, “emerging markets” means “risky markets”. But 85% of the EMD universe is now investment grade. Some countries, such as South Korea, have clearly emerged and are now important global economies. On average emerging markets have about one third of the debt-to-GDP levels that the US, Europe, and Japan do.

 And they are growing faster. Perhaps we should be calling them “growth markets” as some people have suggested, since what they have in common is higher growth rates than developed countries.

 8. Currency within EMD can be volatile, how important is currency when choosing an investment for an EMD portfolio?

 Over time, rapidly growing countries tend to see their currencies appreciate, particularly as they move from the periphery to the centre of the global economy. Think about the US a century ago. It was the “emerging market” versus the UK. One British pound then was worth about five US dollars; today, only about one and half.

 Fifty years ago Japan was an emerging market, one US dollar was worth about 360 yen. Today, it is worth less than 80. While not all emerging market currencies are likely to appreciate the way the US dollar did against the pound, and the yen against the dollar, several have the potential to do so. If you believe globalisation will continue, in our view currencies may be a way to potentially capture this trend.

 9. Global bond indices are known to be “backward looking” in their design, how has this affected portfolio allocation to EMD?

 A global bond index today is comprised of about 95% US dollar, Euro, Japanese yen, and British pound.

 The other 5% is Swiss franc, Australian and Canadian dollars, and some other small currencies. That is because these countries are actually the most highly indebted with largest bond capitalisation. But EMD comprises probably 15% of the global bond market. And in today’s low interest rate environment, investors might even consider a larger tactical allocation.

 

 

 10. Global bond (developed market) portfolios have experienced downgrades in recent times; What are the risks associated with exposing a portfolio only to these markets, in the current economic environment? And what are the potential diversification benefits of including EMD?

 The big risks to global bond indices today are two-fold. Firstly, most major markets have negative real interest rates relative to inflation in their markets; this is a result of policies during this historic economic slowdown. Interest rates are artificially low, so investors are losing money versus inflation if they hold global bonds until maturity. Secondly, developed countries are printing money via deficit spending and quantitative easing, and this could debase currency values over time. So investors today in global bonds suffer poor yields (generally less than 2% for ten year bonds), and the potential of currency depreciation versus emerging market currencies.

Emerging Markets FOCUS

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