Emerging market debt has held up relatively well during the recent turbulent financial market environment.
This bears testament to the strong investment case that can be made for the asset class.
The troubles in the eurozone relating to sovereign debt remain a concern and have led to the possibility of the global economy tipping into a double-dip recession scenario, whereby growth rates turn negative once again and the prices of risk assets fall.
This is very much a worst-case scenario, with the most likely outcome being a drawn out period of slow growth. Emerging markets, on the other hand, look likely to experience much healthier economic expansion as they are less burdened by the excesses of bailing out large financial sectors, making government spending cuts unnecessary.
The decoupling of the developing economies from their developed counterparts has not happened fully so emerging markets are still influenced by their developed world trading partners, but the coupling is less pronounced than previously.
Overtaking
Emerging market growth is becoming more and more self-sustaining as the developing world’s share of global consumption steadily increases.
Of course, emerging markets are dependent to a degree on global growth as their model has typically been to invest foreign exchange receipts received from exports into the domestic economy, but looking at the breakdown of global consumption we can see that the percentage share from emerging markets as a whole is on an upward trend, currently overtaking that of the US and forecast to reach 50% of the total over the next ten years.
Therefore, reliance of emerging markets on G7 countries is falling, and the impact of slower growth in developing markets diminishes as emerging markets become more reliant on each other rather than developed world trading partners.
Depending on what measure you take, you could argue most, if not all, investors are underweight emerging market bonds. Investors are always looking to procure a share of future production, thus gaining an income stream from that production.
Given income and payments from government bonds come from tax revenues, measuring the percentage of total tax revenues from emerging markets is a useful analysis. In fact, emerging market tax revenues have been growing as a share of total tax revenues and they now stand at roughly 30%. It is fair to say few, if any, investors currently have 30% of their government bond allocation invested in emerging market debt.
Another important factor to consider is risk. What are the risks of you not getting paid that share of future production? A large debt level and a relatively small revenue base suggest there is a danger an investor may not get their full share of future revenue.
Analysing the debt-to-GDP ratios of the emerging market members of the G20 shows their ratios are set to remain steady over the next five years at relatively low levels, whereas the developed market members are following an unsustainable fiscal policy over this period and their debt ratios continue to grow from an already higher base level. This makes a compelling case then to avoid developed market debt and allocate to emerging market debt instead.
Record lows
Similar conclusions can be made when we look at monetary policy discipline. Central banks in the developing world have slashed interest rates to record lows and look likely to keep them there for a sustained period, seemingly regardless of any inflationary pressures that may or may not exist.
In contrast to their developed market counterparts, the emerging market central banks have stuck to their mandate of targeting inflation and have begun to deliver interest rate hikes in order to keep prices and growth in check. There is little reason to be concerned higher interest rates will be detrimental to economic growth in emerging markets.
Higher interest rates are far less likely to derail economic growth in developing economies because high interest rates have been a feature in the developing world up until very recently, meaning raising rates is viewed as normalisation. On top of this, emerging market exporters are well equipped to remain competitive despite rising input prices as technological and labour productivity developments improve capital efficiency.
Questions
An obvious question for investors is what impact interest rate hikes will have on bond yields, and hence returns from emerging market debt. Interest rate hikes have already been forthcoming in a number of emerging market economies, and while they must be viewed on a case-by-case basis as to their full impact, interest rate hikes may already be priced into bond yield curves, meaning bond yields would have already moved to reflect anticipated changes in base interest rates.
In fact, in many cases there appears to be more rate hikes priced into bond yield curves than are likely to be delivered, partly thanks to the anaemic growth in developed markets and the likely impact this will have in slowing emerging market growth slightly, thus reducing the need for interest rate rises. This factor has seen emerging market bond yields exhibiting a downward trend over the past month, boosting performance.
Inflation-linked bonds
One particular sub-asset class that is interesting within the emerging market debt space is inflation-linked bonds, the issuance of which has been growing steadily over the past few years. The market has been around for a number of years in Latin America, where inflation indexing has been a part of life for decades, but less so elsewhere.
The development of the pension fund market has brought a natural buyer of inflation protection, leading to issuance of inflation-linked bonds catching up with issuance of external debt, although it remains some way behind issuance of local currency debt with fixed coupons. Currently, inflation-linked emerging debt is offering among the highest real yields available and has the additional benefit of protecting against possible spikes in inflation.
With the global economy still in a state of flux and investors still cautious and looking for ways to invest with less risk, there are several reasons for why emerging market debt remains a compelling investment opportunity.
Anne-Sophie Girault is head of client portfolio managers - fixed income at Aviva Investors
