Caroline Gorman & Paul McNamara from Julius Baer say growth in emerging markets is outstripping growth in the developed world.
Emerging markets are stronger now than they have been for years, yet this has not given them immunity from the global financial crisis. However, EM growth rates are outstripping those of the developed world and look set to continue into 2010
Concern about eurozone sustainability is affecting risk appetite across the spectrum. While this might change now the rich countries of the EU have stepped in to bail out Greece, which might allay fears about other faltering economies of the zone, emerging markets have not been immune to the malaise created by the crisis.
This seems incongruous. Emerging-market economies are stronger than they have been for many years. The bulk of developing countries have smaller budget deficit-to-GDP and debt-to-GDP ratios than, to name but three, the US, the UK and Greece. EM growth rates are outstripping those of the G3 (the US, the EU and Japan) and this should continue through 2010.
Fiscal housekeeping
India is an exception to the good fiscal housekeeping policies of EM countries, with a high budget deficit. But this should be seen in the context of its exceptional growth, expected to be as high as 8% this year, according to some analysts. By contrast, in 2010 the US is expected to grow by 2.7%, Germany 1.5% and the UK by 1.3%, according to projections from the IMF.
Strong growth, of course, makes it easier to lower debt-to-GDP ratios: put simply, the extra revenues generated by growth can be used to pay down debt without destroying the foundation of the economy’s advance. Low growth, highly indebted countries, however, can get trapped in a vicious cycle, in which attempts to rein in the budget deficit by cutting spending or raising taxes only serve to depress domestic consumption and growth even further.
Dynamics
Emerging markets are now the most dynamic part of the global economy. This is partly because of their lower debt-to-GDP ratios, and partly because they are not suffering under the sort of burdens needed to support an ailing banking system, unlike many developed countries. EM economies emerged from the financial dislocations of 2007-2008 with their banking systems largely unscathed (with the main exception being Eastern Europe), which means fiscal expansion in most EM countries can be invested in the economy. EM countries can therefore put more financial resources to work on stimulating growth, giving them more development bang for their fiscal stimulus buck.
EM countries have been good at building up foreign exchange reserves in recent years, a policy that arguably helped EM FX perform more favourably during the global credit crisis than it otherwise may have compared to previous crises. The creditworthiness of EM sovereigns is high – they do not have a lot of debt. And as a result of globalisation, EM countries are moving up en masse compared to developed economies. The expected convergence of incomes between EM economies and the developed world favours real appreciation of EM currencies.
Reforms
Economic reform has been a significant factor in the success of EM countries. The adoption of sensible fiscal and monetary policies by many governments has fostered stability and growth, boosting economic fundamentals. Inflation is now moderate by historic standards, and many emerging nations now run current-account surpluses as commodity exporters have been aided by strong growth, in China in particular.
Emerging countries often have a favourable demographic picture, with younger populations relative to more developed countries. Some EM markets, such as Brazil and Indonesia, have large populations moving up the income scale, making it easier for these countries to generate domestic growth without relying too much on global economic trends.
These growing workforces will drive domestic consumption and, ultimately, fuel economic growth, all of which suggests the pace of growth in emerging markets will continue to outstrip that of developed markets for the foreseeable future.
Local currencies
Interest rates in EM countries – in stark contrast to the G3 – have largely bottomed out. They could be expected to start to climb, though aggressive tightening is unlikely. Nevertheless, the yield differential is expected to move in favour of EM foreign exchange which, along with growth differentials, should support local currencies in 2010.
Developing economies offer a mix of sovereign, municipal, corporate and structured debt, just as developed countries do. In recent years, EM countries have moved towards funding themselves in their local currency and away from external issuance. Local EM debt on issue has doubled in the last five years, to around $1trn. This is around three times the amount of EM hard currency debt on issue.
The development of local-currency debt markets has been motivated by governments’ desire to reduce their exposure to fluctuations in the exchange rate. Demand for local-currency debt has increased hand-in-hand with the development of the pension fund industry. Pension funds seek local-currency-denominated debt because they need to match assets and liabilities. Also, improving governments’ resilience to shocks has required a shift away from short-term, floating-rate debt and debt linked to inflation and the exchange rate.
Differentiation
This has created greater differentiation between the debt markets in different countries. Fifteen years ago, EM debt was a fairly homogenous family – sub-investment grade and US dollar-denominated. Local-currency debt is generally more sensitive to domestic developments such as inflation, a country’s currency performance and its fiscal and monetary policy framework.
In making investments in local-currency EM debt, the important thing is to place a great deal of emphasis on the ‘currency decision’ – deciding first whether a currency is likely to appreciate before buying a bond.
The bond investment decision is secondary to the currency decision as it is rare local currency bonds will rally over time if the currency is weakening. Unless circumstances are exceptional, there is no merit in holding bonds with the currency risk hedged out. As emerging market fundamentals favour EM FX appreciation, exposure to EM FX is a key driver of returns in this asset class. Historically, the FX return has often been greater than the returns from rising bond prices. Why hedge that out?
Caroline Gorman & Paul McNamara, managers of the Julius Baer Local Emerging Bond fund for Augustus Asset Managers
