The Case for Emerging Markets Debt: Stable Fundamentals Support Potential Yield Opportunity

Transcription

1 The Case for Emerging Markets Debt: Stable Fundamentals Support Potential Yield Opportunity SEPTEMBER 214 EMERGING MARKETS DEBT TEAM EMD investable markets are now roughly three times the size of the U.S. high yield market. For emerging markets debt (EMD), reality is overtaking reputation. With its roots in the Brady bonds of the 198s, EMD has historically been perceived as a high-volatility, low-quality segment of the global fixed income universe. But as emerging market economies have grown and stabilized, and as the monetary and fiscal backdrop in many countries has matured, EMD increasingly reflects these gains, with a varied array of investment choices of which the vast majority are investment grade. Despite these advances, however, many segments of EMD retain significant risk premia versus developed market counterparts, offering what we consider significant opportunity for risk-adjusted return potential. MAJOR ASSET CLASS HIDES IN PLAIN SIGHT The size and significance of the economies represented by EMD is undeniable, but many investors choose to look the other way. Emerging markets (EM) economies represent roughly 83% of the world s population, 64% of foreign exchange reserves, and nearly 41% of GDP at market rates (see Figure 1). And EMD investable markets are now roughly three times the size of the U.S. high yield market. Yet they account for only 7% of the global bond market. 1 Even more striking, less than 2% of U.S. pension fund assets are in the asset class. 2 We think this dichotomy reflects the rapid evolution of the EMD marketplace and a lag in adjustment; but it also shows an unfamiliarity on the part of investors, which is heightened by a lack of research coverage and wariness of unfamiliar risk. We believe it is a matter of time before institutions gradually correct this underweight. FIGURE 1: GLOBAL PRESENCE, UNDERREPRESENTED ASSETS Emerging Economies as % of Total World Population 82.9% 17.1% Land Mass 75.1% 24.9% Foreign Exchange Reserves 64% 36% GDP at PPP GDP at Market Rates 49% 41% 51% 59% Equity Market Cap (Float Adjusted) 15% 85% Debt Market Cap 7% 93% Emerging Markets Developed Markets Sources: World Bank (Population as of 21, EME Market Cap as of 212), CIA World Factbook (FX reserves as of 212), IMF World Economic Outlook (GDP at PPP as of 212). EMD figure: JP Morgan, as of May 214. Private Equity figure: Bain 213 Global Private Equity Report and EMPEA. 1 Source: JP Morgan, as of May Source: Morgan Stanley,

2 HEALTHY FUNDAMENTAL LANDSCAPE EMD has come a long way from its early days. During the 198s and 199s, emerging market countries experienced rolling crises, largely stemming from unsustainable fixed exchange rates pegged to the U.S. dollar. In addition to refinancing their debt through U.S. dollar-denominated Brady bonds, governments began to implement more disciplined monetary and fiscal policies. They abandoned fixed exchange rate regimes, reducing external debt levels, and fought high inflation through tighter monetary policy. Today, in an era when developed markets total public sector debt exceeds 1% of GDP, emerging market government debt remains stable at well under 4% (see Figure 2). FIGURE 2: LOW LEVERAGE VERSUS DEVELOPED COUNTERPARTS Government Debt as % of GDP 12 1 The long-term accumulation of FX reserves has also been a key aspect of the emerging markets story F 215F Advanced Economies Emerging Markets Source: IMF World Economic Outlook, as of April 214. The long-term accumulation of FX reserves has also been a key aspect of the emerging markets story. Once EM countries abandoned currency pegs and allowed their currencies to float, they were able to accumulate substantial foreign currency reserves, positioning themselves as net creditors to the world for the first time. The steady increase of foreign direct investment (FDI) (see Figure 3) has also contributed to the structural health of EM capital accounts. Last year s period of EMD weakness was in part tied to cyclical trade deficits in some countries, but with higher interest rates and some adjustment in domestic demand, the issue is being alleviated. Overall EM international reserves stand at U.S. $8.9 trillion, or roughly 8% of global reserves, and at $5 trillion if China is excluded. 3 3 Source: Merrill Lynch, as of March

3 FIGURE 3: FOREIGN DIRECT INVESTMENT IN EM COUNTRIES Volumes (U.S.$ billion) % GDP. Source: IMF World Economic Outlook, as of April 214. The cumulative effect of improved fiscal, monetary, and current account positions has been a secular improvement of emerging market credit ratings. Reflecting these positive trends, emerging markets have been able to maintain their structural advantage in GDP growth over developed market counterparts supported by abundant natural resources, labor cost advantages and attractive demographics, along with the steady attraction of FDI to finance business growth. Despite the temporary weakness alluded to above, countries are increasingly looking to domestic demand as the engine for growth, fueled by increased wealth creation and the resulting expansion of the middle classes across regions. FIGURE 4: STRUCTURAL GROWTH ADVANTAGE Global GDP Growth (%, year-over-year) F 215F Differential Advanced Economies Emerging Markets Source: IMF World Economic Outlook, as of July 24, 214. TRANSFORMATION IN CREDIT QUALITY The cumulative effect of improved fiscal, monetary, and current account positions has been a secular improvement of emerging market credit ratings, a trend that continued after the 28 financial crisis as emerging countries proved resilient given their relatively strong economies and low government debt levels. Today, over 7% of the benchmark JP Morgan EMBI Global index is now rated investment grade, with an average credit rating of BBB-/Baa Source: JP Morgan, as of August 5,

4 FIGURE 5: EMD IS PREDOMINANTLY INVESTMENT GRADE Emerging Market Sovereign Ratings, % of EMBI Global Market Capitalization by Credit Bucket NR B BB IG Source: JP Morgan, data through July 31, 214. Curiously, the improvement of credit fundamentals is not yet fully reflected in emerging market yield spreads, as both sovereign and corporate issues generally provide yields that are higher than comparable U.S. securities. In today s still low-yield environment, EMD provides an attractive alternative to developed market bonds as a source of income. FIGURE 6: EMD OFFERS GENEROUS YIELDS As of June 3, 214 7% 6.54% The improvement of credit fundamentals is not yet fully reflected in emerging market yield spreads. 6% 5% 4% 3% 5.31% 5.22% 4.8% 3.67% 2.28% 2.6% 2% 1.41% 1% EMD HC EMD LC U.S. High Yield European High Yield U.S. IG Credit European IG Credit U.S. Treasuries EMU Peripheral Source: JP Morgan, as of June 3, 214. Benchmarks used are EMD HC (JPM EMBI Global Diversified), EMD LC (JPM GBI- EM Global Diversified), U.S. IG Corporates (JPM U.S. Liquid Index), U.S. HY Corp (JPM HY), U.S. High Yield (JPM U.S. Domestic HY), European HY (JPM Euro HY), U.S. IG Credit (JULI); European IG Credit (Maggie), U.S. Treasury (GBI U.S.), EMU Peripheral. DIVERSIFICATION BENEFITS Another key to the asset class and its appeal is diversification. EMD has historically exhibited lower correlation with U.S. Treasuries and global government bonds, making them a useful diversifier within a broad fixed income portfolio. Figure 7 (on page 5) shows the favorable risk/return relationship associated with EMD blend portfolios (which combine local and hard currency strategies). 4

5 FIGURE 7: ATTRACTIVE RISK/RETURN PROFILE 1-Year Period Ended June 3, 214 Annualized Return 12% 1% 8% 6% 4% U.S. IG Corp U.S. Treasury Blend EMD U.S. HY Corp U.S. Equity EM Equity 2% We expect the EMD sector to continue its long-term expansion, augmenting potential investment opportunities over time. % % 5% 1% 15% 2% 25% 3% Annualized Risk Source: JP Morgan, as of June 3, 214. Benchmarks used are Blend EMD (JPM EMBI Global Diversified, 5%; JPM GBI_EM Global Diversified, 25%; JPM CEMBI Global Diversified), U.S. IG Corporates (JPM U.S. Liquid Index), EM Equity (JPM EM Free), U.S. Equity (S&P 5 Index), U.S. High Yield (JPM U.S. Domestic HY), U.S. Treasury (GBI U.S.). Past performance is not necessarily indicative of future results. As with any investment, there is the possibility of profit as well as the risk of loss. Finally, EMD is a large and frequently inefficient marketplace, especially where bonds may not qualify for major indices or lack the investment coverage or sponsorship to achieve appropriate pricing. As such, the market provides a vast array of opportunities for those with the resources and expertise to assess local conditions, risks and return potential in hard currency sovereign, local currency and corporate debt. OPPORTUNITIES AHEAD We expect the EMD sector to continue its long-term expansion, augmenting potential investment opportunities over time. While the overall EMD market is roughly $11 trillion in size, the current investable universe is about $3.5 trillion (combining the market valuation of the three key JP Morgan indices and about $3 billion in local corporate and smaller issues). Extrapolating its historical annual growth rate of 2%, this universe could reach $1 trillion by 22, largely fueled by corporate credit and new local bond issuance. Although EMD is maturing overall, it remains an inefficient asset class. Many markets are underresearched and sometimes relatively illiquid. The resulting anomalies and mispricing can create alpha opportunities for active fundamental managers. EMD managers performance displays a higher dispersion than developed market fixed income managers, highlighting the importance of manager selection within the asset class. Having resources on the ground to conduct research and better access local opportunities is also valuable. While global institutional investors increasingly recognize the benefits of investing in EMD, this is not currently reflected in portfolio allocations, which can be structurally underinvested in the asset class. Over time, we believe that the diversification benefits and yield associated with EMD will help drive further flows into this compelling market segment. 5

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