Optimizing an Allocation to Emerging Markets Debt

Transcription

1 Lazard Perspectives Optimizing an Allocation to Emerging Markets Debt A Changing Landscape Calls for a Flexible Approach In the past, emerging markets debt has benefited from structural tailwinds such as as declining interest interest rates rates and and US dollar US dollar weakness. weakness. Given the recent Given shift the recent in the macroeconomic shift in the macroeconomic and political backdrop, and political we believe backdrop, movements we in these believe factors these are factors more likely are more to dampen likely to asset dampen class returns asset than class enhance returns them. than enhance However, them. shifting However, landscape the shifting is also landscape likely to lead is also likely to increased to lead to dispersion increased between dispersion individual between individual countries and countries currencies, and currencies, creating opportunities creating opportunities to generate alpha. to generate As such, alpha. we believe As such, the we believe best approach the best to approach successfully to successfully navigate such navigate an environment such an is environment one that is unconstrained, is one that is unconstrained, selective, and flexible. selective, and flexible.

2 2 Where We ve Been: A Brief History Emerging markets debt has been one of the best-performing fixed income sectors over the long term, but more recently, the asset class has endured a bumpy ride (Exhibit 1). During what we view as emerging markets golden age, which can loosely be defined as the period from 2003 to early 2013, the stars were aligned for developing countries. China entered the global economy, commodity prices were on a rising trajectory, and the US dollar weakened. As a result, all emerging markets debt asset classes performed extremely well. This period was followed by a significant re-pricing of risk that began with the taper tantrum in the spring of Fears of an abrupt end to the US Federal Reserve s quantitative easing program and subsequent rate hikes gave way to concerns about Chinese growth and a sharp, prolonged drop in commodity prices which weighed on emerging markets fundamentals. Not surprisingly, the riskier segments of the asset class underperformed during this period led by the 35% spot depreciation in emerging markets currencies against the US dollar. External debt was not immune to the bear market conditions as credit spreads widened roughly 250 basis points (bps), but a sharp drop in US Treasury yields in 2014 helped absorb the shock and produce a positive return for the period. In 2016, emerging markets fundamentals and sentiment finally turned the corner. Growth stabilized and commodity prices rallied from historical lows, leading to a sharp rebound in asset prices. Finally, following the US presidential election in November, the asset class suffered a short-term setback, driven by rising US Treasury yields and another bout of currency depreciation, although these conditions reversed relatively quickly. At this juncture, a key consideration for investors is how best to capture the opportunities in both hard and local currency debt amid a new global backdrop and a less homogenous group of countries. A Changing Landscape Despite the episodes of turbulence, long-term investors have been rewarded handsomely for exposure to the beta, or broad market returns, of emerging markets debt. However, we believe the asset class is in the early stages of a new phase where performance will be driven more by alpha, or manager skill, than beta. We believe emerging markets fundamentals are likely to continue to improve against a backdrop of better growth. But, the variation in the performance of individual countries and currencies is likely to increase as we enter what we believe will be an environment characterized by an ongoing but uneven recovery in emerging markets fundamentals, reflation in the United States, and tepid growth in the rest of the developed world. The shifting landscape is likely to have a profound and varied effect on emerging markets economies and investor sentiment, resulting in significant performance dispersion between the so-called winners and losers. Exhibit 1 Emerging Markets Debt Has Produced Attractive Risk-Adjusted Returns over the Long Term EM Golden Age EM Bear Market EM Recovery Post Trump US High Yield External Debt Local Debt Long-Dated Treasuries Bank Loans Global Investment Grade Performance for periods greater than one year is annualized. Time periods: EM Golden Age = 31 Dec 2002 to 30 Apr 2013; EM Bear Market = 30 Apr 2013 to 31 Jan 2016; EM Recovery = 31 Jan 2016 to 31 Oct 2016; Post Trump = 31 Oct 2016 to 31 Mar 2017 Indices: High Yield = Bloomberg Barclays US High Yield Index; External Debt = J.P. Morgan EMBI Global Diversified Index; Local Debt = J.P. Morgan GBI-EM Global Diversified Index; Long-Dated Treasuries = Bloomberg Barclays US Treasury; Bank Loans = Credit Suisse Leveraged Loan Index; Global Investment Grade = Bloomberg Barclays Global Aggregate Index USD Hedged The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg Barclays, Credit Suisse, J.P. Morgan While the recent rise in US Treasury rates may have stirred flashbacks of the taper tantrum for some market participants, we believe the analogy is unjust as emerging markets economies are much healthier than they were just a few years ago. Broadly speaking, emerging markets countries have largely adjusted their external imbalances. Current accounts, which reached their nadir in the lead-up to the taper tantrum, have now improved for three consecutive years. Importantly, there are also clear and sustainable signs of improving emerging markets growth both on an absolute basis and relative to developed markets. Concurrently, inflation is generally stable in emerging markets, while it is creeping higher in developed markets. Lastly, a number of countries including Argentina and Brazil have seen the political pendulum swing in the opposite direction from many developed countries, moving from populist regimes to more market-friendly governments. This is positive for investors as market-friendly governments are likely to enact more conservative fiscal policies, which should pave the way for increased foreign capital and investment inflows.

3 3 Meanwhile, recent developed markets dynamics are likely to weigh on emerging markets debt benchmark returns. A reflationary environment of higher growth and higher inflation in the United States is likely to lead to rising interest rates and US dollar strength. The US Treasury component of external debt returns has been a steady source of income and capital appreciation throughout much of the asset class s history (Exhibit 2). However, given the historically low level of yields today and the balance of risks, US Treasuries are less likely to boost returns going forward and could shift from being a tailwind to become a headwind. We believe that two of the forces that served to anchor interest rates in recent years disinflation and highly accommodative central bank policy are not only fading, but are likely to reverse. Inflation has remained depressed in recent years due to excess slack in the labor market and a sharp decline in commodity prices. However, the United States is now entering the eighth year of its economic recovery and excess slack in the labor market has largely been absorbed. Meanwhile, oil prices have doubled since bottoming about a year ago. As a result, inflation has been on an upward trend since mid-2015 (Exhibit 3). Moreover, the Fed has acknowledged that inflation is likely to exceed its 2% target in coming years. And while the US economy has been showing signs of improving growth for several months, we believe President Donald Trump s economic agenda, including infrastructure spending and tax cuts, is likely to accelerate the process and induce further growth and inflation. Diminishing support from developed markets central banks is also likely to lead to a normalization in core interest rates. The Fed has already moved away from extremely accommodative monetary policy. While the pace of rate hikes thus far has been very gradual, it is likely to accelerate in Similarly, the European Central Bank and Bank of Japan appear to have acknowledged the adverse consequences of negative interest rates on their domestic banking sectors and market participants have shifted their focus to the eventual tapering of each bank s bond buying programs. Fertile Field We believe the changing landscape is likely to have a varied impact on emerging markets countries and is ripe with opportunity. Investors with beta exposure are less likely than before to achieve returns consistent with the asset class s long-term history; however, we believe the alpha opportunity is as compelling as ever because of both top-down macroeconomic themes and idiosyncratic factors (Exhibit 4). In general, higher yielding emerging markets countries with improving external accounts should outperform in a world of higher growth, higher inflation, and higher rates. The same holds true for emerging markets corporates which benefit from lower duration and an additional spread cushion. On the other hand, we believe lower yielding countries with below-trend growth, such as many eastern European countries, are likely to suffer. Additionally, higher yielding countries tend to be commodity exporters and Exhibit 2 US Treasury Component Is Likely to Become a Headwind Spread Return Treasury Return Total Return YTD The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is provided for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. Source: Lazard, J.P. Morgan Exhibit 3 US Inflation Has Been on the Rise for over a Year Dec 14 Personal Consumption Expenditure Core Price Index May 15 Oct 15 Source: Bloomberg, Bureau of Economic Analysis Mar 16 Aug 16 Exhibit 4 The New Era Will Have More Specific Winners and Losers Rising Treasury Yields Commodity Strength US Dollar Strength (relative to the euro and yen) Idiosyncratic Factors Potential Outperformers High yield emerging markets sovereigns Emerging markets corporates Oil-exporting countries High yielding emerging markets currencies Countries entering monetary easing cycles Countries with potential for positive regime change Countries with IMF support Potential Underperformers Jan 17 US Treasurysensitive emerging markets sovereigns Oil-importing countries Low carry European and Asian currencies Countries with deteriorating fundamentals Countries with high/ negative political risk For illustrative purposes only. Information and opinions are subject to change. Source: Lazard

4 4 should benefit from increased US infrastructure spending and a corresponding rise in commodity prices whereas investment grade countries tend to be commodity importers. Given our expectations for higher growth and higher interest rates in the United States relative to the rest of the developed world, we also believe the US dollar is likely to strengthen relative to other developed markets currencies. President Trump has at times indicated his desire for the US dollar to weaken, which would boost US exports and be positive for emerging markets currencies. However, the president s ability to directly impact the US dollar is limited. We are constructive on emerging markets currencies due to improving growth relative to developed markets and a more favorable environment for commodities. However, we believe emerging markets currencies are more likely to perform better relative to those currencies linked to the slower-growth regions of the world such as Europe and developed Asia. There have been similar periods when emerging markets currencies depreciated versus the US dollar, but performed well against other currencies, thus an investor s source of funding for long currency positions is critical (Exhibit 5). A select number of emerging markets countries also stand to benefit from positive idiosyncratic factors. Brazil, which is in the midst of an important macroeconomic transition and reform process, is a very attractive opportunity in local debt markets, in our view. While nominal yields have declined significantly, real yields are in the mid-single digits and are among the highest in emerging markets. Our constructive view on Brazil is driven by two factors monetary easing and fiscal reform. The central bank in Brazil began easing policy in October and accelerated the pace of easing in January. We believe there is significant scope for a decline in both nominal and real policy rates in Brazil, as inflation has peaked and is now falling. Our expectation of fiscal and micro reforms is another factor driving our constructive outlook for the country. Elsewhere, regime changes towards more market-friendly governments have been a major source of outperformance which is uncorrelated to the broader market environment, as evidenced by Argentina (2015) and Brazil (2016). With a busy election calendar in 2017 and 2018, we believe this trend will continue. Finally, countries such as Ukraine, Ecuador, and Ghana have aid packages in place with the International Monetary Fund (IMF) or are expected to enter into similar agreements. The Right Tools to Reap Alpha We believe selecting the optimal approach to emerging markets debt is critical in the current environment. As we enter a new era where emerging markets debt benchmarks may be challenged by duration, US dollar strength, and the significant underperformance of select countries, we believe investors should favor a total return approach to the asset class. Exhibit 5 Emerging Markets Currencies Are Attractive, but the Currency Used to Fund Long Positions is Critical December 2002 = Source: Lazard, Bloomberg, J.P. Morgan EM vs. USD GBI REER Exhibit 6 Rising Rates Could Significantly Erode External Debt Returns Total Returns Under Rising Rate Scenarios External Debt +50 Investment Grade External Debt +100 Strategies constructed relative to a benchmark and that are bound by constraints are inherently limited in their ability to fully mitigate risks that are not well compensated. For example, the external debt benchmark has a duration of 6.7 years, thus even a modest rise in interest rates could generate capital losses that would significantly erode the positive carry in external debt (Exhibit 6). Index country concentrations pose further challenges for benchmark-oriented investors. Turkey and Mexico collectively compose 20% of the local currency index and returned -18% and -11%, respectively in the fourth quarter of Thus, an investor with a benchmark-neutral allocation would have realized a capital loss of nearly 3%, a material drag for a fixed income investor in any return environment. As a result, we believe benchmark-driven approaches to emerging markets debt may be too restrictive for some investors in this environment. For investors with a greater +75 High Yield External Debt Change in Yields (bps) Scenarios assume an instantaneous change in yields and no change in spreads. Source: Lazard, J.P. Morgan

5 5 Is a Total Return Approach a Good Fit? Potential Benefits Considers the entire emerging markets debt investment universe Ability to hedge uncompensated risks Flexibility to invest only in attractive opportunities, while avoiding those that are unattractive Ability to dynamically manage portfolio beta Potential for better risk-adjusted returns over the long term Potential Drawbacks Outsourcing of asset allocation and beta decision Tendency for returns to lag over the short term in strong beta rallies Challenges in measuring performance For illustrative purposes only. Information and opinions are subject to change. emphasis on capital preservation, we believe the optimal starting point for constructing an emerging markets debt portfolio today may be cash, rather than a benchmark index. We define a total return strategy as an unconstrained, selective, and flexible approach. A total return strategy is unconstrained in that it considers the entire emerging markets debt universe, including sovereign credit, corporate credit, local rates, and local currencies, as well as derivative instruments. The management team has the flexibility to allocate capital to their best ideas and can completely avoid risks that are not well compensated. While this approach differs from a pure absolute return strategy, we believe a manager should also have the freedom to take directional shorts to hedge at both the overall portfolio level as well as the individual security level in order to isolate the risks that the manager wishes to take. For example, in the current environment a manager may wish to hedge interest rate risk in order to isolate spread risk. Additional strategies to generate alpha may include relative value positions or the funding of long positions in currencies other than the US dollar. Importantly, we believe investors must recognize that the benefits of a total return approach come with risk factors that are not associated with a traditional benchmark-driven approach. First, rather than having a more or less static beta to the asset class, the total return manager has the ability to dynamically manage the portfolio s beta. While this typically allows for better capital preservation in down markets, the corollary is that the total return manager will typically lag the asset class in a sharp beta rally. Second, the lack of a benchmark and the high conviction nature of this approach means that manager skill is the primary driver of returns. Thus, manager selection is critical to the successful implementation of a total return strategy, in our view. An additional issue facing total return investors is how to judge performance. As discussed, we believe the current phase of the market cycle is particularly suited to a total return approach, which we expect to outperform traditional benchmark indices over the medium term, with significantly less volatility. While investors should expect the performance of a total return portfolio to deviate meaningfully from the broader asset class over the short term, a benchmark blending external and local currency debt should provide a good indication as to whether a total return manager has achieved an attractive risk-adjusted return over the long term. We believe an important shift is under way in the emerging markets as several continue to show signs of improvement and the universe of potential investments is ripe with opportunity. But changes in developed markets are increasingly likely to weigh on benchmark returns. Investors can no longer depend on falling US Treasury yields to provide a boost to performance. Thus, we believe investors should look beyond traditional benchmark-driven approaches when allocating to emerging markets debt.

6 6 About The Team The Lazard Emerging Markets Debt team focuses on understanding the entire opportunity set in our investment universe as a means to generate attractive risk-adjusted returns for our investors. Our portfolio managers have worked together to manage total return portfolios since 1999 and are supported by 10 dedicated analysts. The team employs a consistent process that integrates macroeconomic views with rigorous fundamental research, emphasizing risk management. The team works alongside Lazard s emerging markets equity managers, granting them unique insight into currency movements, the stability of equity and debt structures, and the broad business environment. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Important Information Published on 18 April Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as junk bonds ) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. 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