Amid all the apparent short-term doom and gloom that tapering has in stock for emerging-market debt (EMD), we believe the future for emerging-market (EM) economies in the medium and long term is undeniably positive. These countries, and EMD as an asset class, are experiencing growing pains as they move from childhood to puberty. They should reach economic adulthood when these economies find a development model that pursues the critical drivers of diversification, rapid and sustainable productivity gains, critical mass in domestic capital formation and a supportive investment climate, among several other factors.
EMD had been the darling of the fixed-income world for the prior three years, with inflows into the asset class beating records year after year, until the events of this past summer.
As we move into 2014, after what is coming to be a rather volatile 2013, asset allocators will be pondering once again what size of an allocation they should make to emerging-market debt. This awkward moment comes on the back of what appears to be almost certain negative returns for all types of emerging-market debt this year. The volatility experienced during the summer months is still very much in the back of people’s minds and is reminiscent of the troubled days of old for the asset class, when the average rating was BB.
So why is it that a fundamentally attractive asset class can still give people heart palpitations, and what is the silver lining that outweighs all these concerns?
Most allocators are still buying the “package” in one size fits all
When it comes to EM debt, whether denominated in USD or local currencies, most allocators have been, to an extent, only paying attention to one single unique selling proposition, regardless of idiosyncratic attributes attached to regions and countries. This lack of apparent sophistication also stems from the fact that most investors in the developed world were reluctant buyers of this class in the past. As financial repression accelerated after 2009, crossover allocators were slowly forced into the EM class, looking for yield and diversification. Allocations remain relatively small, with investors wanting a single offering that embodies the EM promise.
With the average EMD allocation set at 3 per cent at best, investors riding the carry trade have been trigger happy at the slightest signal that monetary accommodation is coming to an end. EMD as a market has thrived in times of higher US Treasury rates, but the upcoming Fed taper, when it happens, may create substantial dislocation in valuations.
The truth is that EM issuers and investors have become complacent after many years of easy money. Some EM countries are responsible for stalling the reform agenda as their external reserves swelled thanks to the commodity windfall. And many investors have ignored sovereign idiosyncratic risks when buying EMD across the board; they may be up for a harsh wake-up call when rates normalise.
Portfolio outflows are likely to follow the one-size-fits all approach as rates normalise, systematically hitting all EM credits equally at the beginning. The summer volatility from earlier this year gave us a flavour of what may be in store in the future.
A Volatile 2013
Sovereign-debt yields in emerging markets soared
this past summer after large-scale selloffs.
Source: JPMorgan as at 2 December 2013
The glass is half full
Whatever the short-term dislocation the taper may bring, structural momentum is still intact. In the meantime, the immediate positives to seize the opportunity in the aftermath of the upcoming correction are:
- The silver lining for EMD is still there: Young populations, urbanisation and infrastructure leading ultimately to growth provide a solid rationale to remain invested.
- Countries’ credit quality, although slightly deteriorating at the moment, is far off the 1990s-style crisis scenarios. We are not anticipating rising default probabilities at sovereign, corporate investment grade or the vast majority of the high-yield spectrum in emerging markets.
- As reality bites and countries’ sustainable growth becomes harder to achieve, the reform agenda will be back in focus.
- Valuations will be greatly distorted as rising liquidity premiums take centre stage, providing unique opportunities for seasoned investors in the field. Local currency will provide unbeatable carry and a low forex entry point in emerging-market local currencies if the market tests the summer lows again.
- Corporate credits in the sovereign orbit or defensive sectors that are not overly exposed to forex volatility will prove resilient and capable to deliver superior income in short- duration segments.
These factors will be back in focus once it becomes evident to the naked eye that valuations have become grossly dislocated against fundamentals. It takes an experienced manager to pay attention to idiosyncratic risk when selecting countries and avoid the perils of one size fits all.
Beyond the initial risks that the taper brings to the EMD universe, the level playing field in EMD managers is bound to materially change as incumbent managers are likely to be challenged in these conditions. Any meaningful dislocation will also present a unique opportunity for Allianz Global Investors to persuade investors to raise their EMD allocations the smart way.