EMERGING MARKETS: POSITIONING FOR NORMAL

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1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. PLEASE REFER TO ALL RISK DISCLOSURES AT THE BACK OF THIS DOCUMENT. EMERGING MARKETS: POSITIONING FOR NORMAL INVESTING IN EMERGING MARKET BONDS WHEN MAJOR CENTRAL BANKS TIGHTEN POLICY SEPTEMBER 2017 > Normalisation of monetary policy in developed markets is often cited as a risk to emerging market investment, but a stronger global economic backdrop and lower vulnerability in key markets should mitigate some of these risks.

2 Many investors believe that emerging markets are now an attractive investment opportunity, but worries about rising developed market interest rates are a lingering concern. Although developed market central banks are in the process of gradually normalising interest rates, the backdrop of an improving outlook for global growth with benign inflation is a positive one for emerging market assets, allowing them to more easily manage tighter developed market policy. Relative to the taper tantrum period, in which there was significant volatility in some markets, external vulnerabilities have been reduced with lower current account deficits and higher real yields in the five markets which became known as the fragile five during that period. Our core scenario is for yields in major developed markets to remain anchored, but in a scenario where yields do move gradually upwards the higher nominal yields available in emerging market local currency and corporate bonds should cushion investors against bond price falls. For local currency bonds, currency risk needs to be appropriately managed in order to control volatility and avoid potential losses. A larger and more rapid upward adjustment to yields would, of course, be likely to have more disruptive implications for all assets. Especially for emerging market corporate debt, it is important that investors do not look only at headline index numbers, as valuations vary on a regional and country level. At this stage in the investment cycle, alpha can be more important for returns than beta.

3 EMERGING MARKETS: POSITIONING FOR NORMAL INVESTING IN EMERGING MARKET BONDS WHEN MAJOR CENTRAL BANKS TIGHTEN POLICY ACCORDING TO RESEARCH FROM THE INSTITUTE FOR INTERNATIONAL FINANCE, NET CAPITAL INFLOWS TO EMERGING MARKETS WILL TOTAL $78BN IN 2017, ACCELERATING TO $167BN IN 2018 AND REVERSING THE TREND OF SIGNIFICANT OUTFLOWS IN 2015 AND THIS IS CAUSING MANY INTERNATIONAL INVESTORS TO TAKE A FRESH LOOK AT EMERGING MARKET ASSETS. A COMMON CONCERN WE HEAR IS THE PROSPECT OF RISING DEVELOPED MARKET INTEREST RATES AND HOW THIS WILL AFFECT YIELDS AND VOLATILITY IN EMERGING MARKET ASSETS. In our view, in order to address this question, it is critical to consider the potential catalysts for higher developed market yields. The global growth outlook is improving and output gaps in the developed world have closed, causing labour markets to tighten and boosting global trade. Developed market inflation has moved moderately higher and fears of global deflation have now passed, but disruptive technological change and globalisation are still powerful disinflationary forces. Global energy prices, typically a factor driving inflation higher during periods of stronger global growth, are being constrained by increasing US shale oil production. In this environment, major central banks have room to normalise interest rates gradually, led by the US. For emerging markets, this backdrop of improving global growth and constrained inflationary pressures is likely to provide a cushion against the volatility which could be caused by rising developed market yields. Real yields in local currency emerging debt markets are historically high, as the pass-through to inflation from previous currency devaluations and the rise in global energy prices dissipates. A rise in developed market yields, where real yields are historically low, would not necessarily translate into a rise in local market yields of a similar magnitude. If emerging market yields were to move to a similar degree, then the higher level of nominal yields would provide far greater protection to investors than the yields of most developed market countries. To demonstrate this, Figure 1 provides analysis which shows the returns generated from each of the asset classes in emerging market debt under various interest rate scenarios. Figure 1: Scenario analysis on total returns of different yield changes over 12 months % Sovereign USD Local currency debt (unhedged) Corporate debt (USD) Corporate investment grade Corporate high yield Yield Duration bp +25bp -25bp -50bp Figure 1: Source: JP Morgan. As at end August 2017.

4 But why, investors ask, are emerging market assets not going to experience a more violent reaction, as occurred in recent history when the US Federal Reserve first raised the prospect of winding down its quantitative easing (QE) programme (the period known as the taper tantrum)? Does, for example, the recent announcement regarding balance sheet reduction in the US have the potential to cause a similar episode of volatility once this policy is enacted? If developed market yields were to rise rapidly and in a disorderly fashion, then it would potentially be disruptive for all assets, especially where valuations are extended. Assuming an orderly adjustment in yields, there are reasons to believe that the outcome would be very different. By announcing that it would taper its QE programme the Federal Reserve caused US bond yields to move higher, drawing capital back towards the US as it sought to take advantage of the higher interest rates available. Under different circumstances this change in capital flows could well have been easily absorbed with limited volatility. For years leading up to the taper tantrum, capital had been flowing towards emerging markets, driven by stronger growth dynamics at first, then in a search for yield following the global financial crisis. External vulnerabilities had steadily increased especially in Brazil, India, Indonesia, South Africa and Turkey, which would become known after the taper tantrum as the fragile five. The aggregate current account position of those five countries moved from a surplus of $17bn in 2003 to a deficit of $255bn in Figure 2: US dollar current account positions of fragile five countries USD billion Brazil India Indonesia South Africa Turkey Figure 2: Source: IMF. As at end August (2017 figures forecast).

5 The fragilities that existed within a small group of emerging market countries in the lead up to the taper tantrum have, to a large extent, been dealt with, making this group considerably less vulnerable. As capital inflows waned, they were no longer sufficient to finance this large current account deficit, and currencies weakened to reflect this new reality. Central banks raised interest rates in order to attract capital back towards their asset markets, but despite this, currencies weakened further meaning the central banks were also faced with accelerating inflation due to the higher cost of imported goods. Further rate hikes ultimately led to severe economic contractions. Today, many of the vulnerabilities which faced emerging markets in 2012 and 2013 have been addressed. The aggregate current account deficit of the fragile five countries has dropped from its peak of $255bn to just over $100bn in 2016, although it is projected to rise to $133bn in Although inflation has moderated across many emerging markets, central banks have not reduced interest rates at the same pace, allowing real yields to grow. Using current consensus forecasts for end-2017 inflation, all of the previous fragile five economies are expected to have positive real yields based on their current 2-year local government yield. Turkey has the lowest buffer, its central bank constrained by domestic political factors. Market participants now widely expect developed market central banks to normalise policy over the coming years; this stands in contrast to the shock of unexpected policy change experienced during the taper tantrum. If policy were to tighten more rapidly than currently expected, then that would potentially pose a risk to capital flows into emerging markets, but even in that scenario, the most vulnerable markets have reduced their need for foreign capital. Vigilance is still required in the medium term, as capital inflows combined with strengthening domestic economies could see these improvements reverse and current accounts return to problematic levels. Figure 3: 2-year real yields in 2012 and Figure 3: % USA Brazil India Indonesia South Africa Turkey As at 31 December 2012 As at 31 December 2017 (forecast) Source: Bloomberg/IMF. As at end August 2017, inflation data consensus forecast for end 2017.

6 Global yields should be anchored, but if yields do rise then the higher nominal and real yields available in emerging markets should create a buffer to shield investors from losses. CONCLUSION Rather than expecting yields to rise, our core scenario is that developed market yields will actually have limited upside, until there is greater evidence that global inflationary pressures are building. In this scenario income generation from emerging market debt should provide an attractive return relative to developed markets. Interest rate policy in developed markets is now well signalled by central bankers, with market participants anticipating normalisation of policy over the medium term. This combined with reduced current account deficits and higher real yields in those markets worst affected during the taper tantrum should lessen the risk of a similar episode for now. For those investors who are expecting a gradual rise in global interest rates, local currency and corporate debt both offer a high nominal yield to buffer against any price falls, but at the same time have a lower duration than US dollar sovereign bonds, making them less sensitive to interest rate changes. For local currency bonds, currency risk needs to be appropriately managed in order to control volatility and avoid potential losses. Policymakers in many emerging markets have become comfortable with using currency markets as a buffer to insulate their economies from negative shocks, so a disruptive upward move in interest rates could also result in potential currency losses. However, we believe that stronger global growth and relatively weak inflation imply only a gradual normalisation of monetary policy by developed market central banks, which should, broadly speaking, be a positive for corporate credit fundamentals while the expectation of historically low net issuance should provide further technical support. A top-down analysis only gives part of the investment story. In order to achieve the greatest value, it is important to delve deep beneath the broad headline index in each asset class and carefully consider fundamentals on a regional and country level, while undertaking rigorous corporate credit analysis. At this point in the cycle market alpha can be more important than beta.

7 Colm McDonagh, Head of Emerging,Market Fixed Income Colm joined Insight in November 2008 as Head of Emerging Market Fixed Income, responsible for all emerging debt strategies. Prior to joining Insight Colm s previous roles included partner at Hydra Capital Management (an emerging market fixed income boutique) and Head of Global Emerging Market Debt at Aberdeen Asset Management. He began his career at Bank of America in 1996 as an emerging market Eurobond trader. He has invested across the wide spectrum of the asset class through long only and alternative strategies. Colm holds a B.B.L.S. honours degree in Finance and Law from University College, Dublin. IMPORTANT INFORMATION RISK DISCLOSURES Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations. ASSOCIATED INVESTMENT RISKS Currency hedging techniques aim to eliminate the effects of changes in the exchange rate between the currency of the underlying investments and the base currency (i.e. the reporting currency) of the portfolio. These techniques may not eliminate all the currency risk. Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise. Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio. FIND OUT MORE Institutional Business Development businessdevelopment@insightinvestment.com European Business Development europe@insightinvestment.com Consultant Relationship Management consultantrelations@insightinvestment.com Client Relationship Management clientdirectors@insightinvestment.com company/insight-investment This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number Insight Investment. All rights reserved

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