Emerging market external debt is establishing itself as a high-quality asset class, writes BlackRock's Imran Hussain
The proximate catalyst for recent volatility, in our view, has clearly been fear surrounding the eurozone sovereign debt markets, led by the deteriorating credit dynamics of Greece and other peripheral sovereign issuers. This culminated in the dramatic ECB/IMF and EU stabilisation package of around €750bn – roughly 8% of European GDP and thus considerably larger than any forecast.
As worries about debt levels in a number of high income countries bring focus on sovereign fundamentals, emerging market sovereigns stand out as having much stronger balance sheets than many of their richer, developed world counterparts.
Emerging market governments have used the strong growth of the pre-crisis period to reduce levels of government debt, improve debt maturity profiles, decrease reliance on foreign currency debt and increase international reserves. These economies were also more resilient through the crisis and are leading in the recovery, with lower public and private sector debt and stronger growth prospects, relative to their developed world counterparts.
It is worth highlighting that GDP growth in global emerging markets has outpaced the
developed world, even in bear markets. Since 1992, the average global emerging market economy has grown by 130% versus 38% for the average G7 economy.
So let’s take a closer look at the key reasons for emerging markets’ resilience and why they have come out of the crisis in a relatively strong position.
First, the countries hit the hardest during the crisis were the ones with the largest levels of credit penetration. However, the overall level of credit penetration in emerging markets has not risen as much as it has in the developed world. Second, during the course of the crisis, the private sector debt problem in the developed world was transferred to the public sector via bailouts and deficit spending.
While some emerging markets did pursue counter-cyclical fiscal policies, the fiscal deficits in emerging markets are much smaller and likely to be more temporary than in the developed world.
So overall, we expect strong credit fundamentals and growth differentials – driven by lower levels of debt – to be the key driver for capital flows into emerging markets and fuel outperformance of emerging market assets in 2010 and beyond. When looking at the emerging market world, we can divide opportunities between two distinct asset allocation decisions.
First, emerging market external debt, also referred to as hard currency debt, is emerging market debt denominated, for the most part, in dollars. As emerging market external debt trades on a spread to US Treasuries, it is viewed as a ‘credit’ product. When looking at an investor’s overall asset allocation, external debt should be viewed as part of an investor’s global credit allocation. When looking at how interest rate policy impacts performance, emerging market external debt is not directly impacted by domestic (local) monetary policy, but rather is affected by the US Federal Reserve’s (Fed) monetary policy.
Over the longer term, spreads on emerging market external debt primarily correspond to a country’s ability and willingness to pay its debt. This is dependent on the strength of the country’s sovereign balance sheet, the country’s stability and its growth prospects.
Second, emerging market local currency debt is emerging market debt denominated in a country’s local currency. Emerging market local debt is affected by domestic (local) monetary policy and interest rate outlook.
Currency valuations correspond to investors’ perception of country risk, growth prospects and balance of payments. As emerging market central banks begin to remove their accommodative monetary policy, this could lead to rising emerging market local yields, disproportionately hurting longer duration local currency bonds.
Over the next 12 months, BlackRock’s emerging market debt team continues to see room for further appreciation in emerging market local currencies.
However, there is room for both types of emerging market debt in an investor’s portfolio as each provides a different benefit. Emerging market external debt is establishing itself as a high quality asset class, with over half of the J.P. Morgan EMBI Global Index rated investment grade.
As part of an investor’s longer-term strategic allocation, investors should consider emerging market external debt as a way to diversify their global credit allocation.
Imran Hussain is BlackRock’s head of emerging market debt portfolios
