PRUDENTIAL FIXED INCOME Emerging Markets And the New World Order March 21 Cathy Hepworth, CFA Principal and Sovereign Strategist Prudential Fixed Income Most emerging markets economies performed comparatively well during the global credit crisis of 27-29. Formerly, economic, monetary, or political crises -- some self-inflicted, some externally-induced -- had kept emerging markets countries from truly and permanently emerging as key contributors to the global economy. The global credit crisis that began in 27 and lasted into 29 was a welcome departure from this pattern. Decades of hard-fought economic and political reforms finally paid off, helping emerging markets countries outperform in the recent global economic downturn. This paper discusses the factors that we believe have contributed to, and will continue to sustain, the outperformance of emerging economies in coming years. Against this resilient backdrop, the prospects for emerging markets debt remain favorable. An Important Legacy of the Global Credit Crisis Emerging Markets Perspectives For more information contact: Miguel Thames Prudential Investment Management 2 Gateway Center, 4 th Floor Newark, NJ 712-596 973.367.923 miguel.thames@prudential.com The global credit crisis that gripped the world during 27-29 was one of the longest, deepest, and most painful in history. It toppled once-venerable Wall Street icons, brought down scores of once-prestigious banks, and shocked the global economy with a deep economic recession and perhaps a deeper crisis of confidence. Its most important legacy, though, may be one that has yet to fully unfold: the crisis also revealed a new world order in terms of economic and market dynamics. By new world order, we are referring to a world in which emerging markets economies finally arrive as powerful, essential, and permanent contributors to global economic growth and sustainability. Why Emerging Markets Economies Will Lead the New World Order There are a number of indications that the time has arrived. First, in contrast to past crises, economic growth in emerging markets economies outperformed growth in developed economies during the recent global credit crisis. During 29, the worst year of the crisis in terms of global economic growth, the GDP of developed countries declined -3.6 on average, while GDP of emerging countries grew +1.7 on average. (Source: International Monetary Fund, or IMF). Moreover, as shown in Figures 1 and 2 below, emerging markets economies, represented here by the BRIC s Brazil, Russia, India and China began their economic rebound earlier than developed markets, at the beginning of 29.
2 Figure 1 Emerging Countries Real GDP ( Over Previous Period, Seasonally-Adjusted Annualized Rate) As of February 26, 21 1 Figure 2 G-3 Real GDP ( Over Previous Period, Seasonally-Adjusted Annualized Rate) As of February 26, 21 1 5-1 -2-3 -4 China India Brazil Russia -5-1 -15 US Euro-zone Japan Source of data: JPMorgan publications, February 21. Projections are not guaranteed and actual results may vary. Importantly, we expect the growth in emerging markets economies to continue. Figure 3 below shows that the growth rates of GDP in emerging markets countries are expected to exceed those of developed markets countries by a sizeable percentage over the next several years. Figure 3 GDP in Emerging Markets Expected to Exceed Developed Markets (GDP Annual Changes) 8 6 4 2-2 -4-6 Emerging and developing economies European Union Japan United States 29 21 211 212 213 214 Source of data: IMF World Economic Database. Data as of October 29. Projections are not guaranteed and actual results may vary. What explains this divergence? For one, over the past ten years, emerging markets countries have clearly benefited from higher global economic growth and higher commodity prices. Their growth was not just a function of higher external demand, but also of rising domestic demand. That isn t the entire story, though. A second important reason is that emerging markets economies implemented better internal domestic policies in addition to policies that reduced their external vulnerability. These structural and fiscal reforms, along with more efficient and credible monetary policy and sound debt management efforts, laid the groundwork for emerging markets countries to benefit from the high levels of global growth that characterized the late 199s and the first two-thirds of this decade. Importantly, these initiatives also helped these countries remain resilient during the recent global crisis. In particular, reducing external debt exposure and building foreign exchange reserves helped emerging markets countries to buy "self-insurance", so when the crisis hit, they were much better insulated. 2
Emerging Countries Have Lower Levels of Government Debt Let s examine these differing internal domestic policies in more detail. One important internal policy difference is seen in government debt levels. While industrialized countries have let their government debt levels rise steadily since 2, the governments of emerging countries have kept their public sector debt under control. This is seen in the graph below: over the past ten years, debt as a of GDP rose in the advanced G-2 economies, while it actually declined in the emerging economies: Figure 4 While Developed Countries Let Their Government Debt Levels Rise, The Emergings Kept Government Debt Under Control General Government Debt Ratios, 2-214 ( of GDP) 12 1 8 6 4 2 Advanced G-2 economies Emerging G-2 economies Source of data: IMF as of October 29. General government debt ratios for 21-214 are IMF projections. Projections are not guaranteed and actual results may vary. The soundness of this fiscal discipline became evident when global GDP growth sharply declined beginning in the 4th quarter of 28. Developed countries became painfully aware of the constraints that a staggeringly high debt burden placed on them during a global economic slowdown. It made the calculus of their fiscal stimulus more difficult, and has limited their ability to grow. From an investor s perspective, it resulted in higher risk premiums for all of their debt, public and private. Post-crisis, the public sector debt ratio is expected to increase further in the developed world, further crowding out the private sector. In contrast, it is expected to remain stable or even decline in emerging market countries. Emerging Countries Have Higher Savings Rates Why were developed countries increasing their debt, while emerging markets countries were decreasing their relative debt ratios? The reason was that emerging economies were both saving and investing in prodigious amounts, helping to support their growth, while developed economies were both dissaving (or borrowing) and also investing less. The dramatic difference in these two variables savings and investment as a of GDP -- between the developed and emerging universe of countries is shown in Figures 5 and 6 below: 3
23 22 21 2 19 18 17 16 15 Figure 5 Developed Countries Savings Rates Have Been Below Their Moderate Investment Levels Savings and Investment: Advanced Economies ( of GDP) Savings Investment 4 35 3 25 2 15 Figure 6 Emerging Countries Savings Rates Have Exceeded Their Substantial Levels of Investment Savings and Investment: Emerging Economies ( of GDP) Savings Investment Source of data: IMF as of October 29. General government debt ratios for 21-214 are IMF projections. Projections are not guaranteed and actual results may vary. There are a number of important observations here. Not only have both savings and investment been declining in general in developed markets, but they have been declining from a lower base. Indeed, savings rates in developed countries have long been below their levels of investment, and both rates have been lower than in emerging markets countries. As Figures 5 and 6 above illustrate, savings rates in developed countries have been in the low 2 range and trending lower, while savings rates in emerging countries have recently been over 3 and trending higher. Because savings rates have been below investment rates in developed countries, those countries must make up the difference by borrowing. On the other hand, emerging countries savings rates have long exceeded their substantial levels of investment. These dynamics, along with the comparatively lower debt burdens of emerging markets countries, help explain why growth in emerging markets countries has rebounded and why it is more likely to be sustainable. Emerging Markets Economies Carry Much Smaller Fiscal Deficits When the fiscal dynamics are included in the equation, the changing fortunes become even more apparent. As shown in Figure 7 below, if we use 27 as a pre-crisis starting point, we can make two observations regarding fiscal policies. First, we see that pre-crisis, developed countries had much smaller primary fiscal surpluses -- fiscal revenues less expenditures, excluding debt costs as a of GDP. We also see that the magnitude of post-crisis deterioration has been dramatic. These economies are not expected to generate a fiscal surplus over the next five years. In emerging markets economies, on the other hand, in spite of the primary deficits expected over the next few years, the negative fiscal balances are much smaller. Furthermore, emerging markets countries are expected to return to surplus by 213. 4
Figure 7 Advanced and Emerging Economies: Primary Fiscal Balances (27-214) Advanced: Primary Balance Emerging: Primary Balance Source of data: IMF World Economic Outlook. January 21. Projections are not guaranteed and actual results may vary. These differences are important and explain why the current sovereign credit crisis is focused on developed countries. Developed countries carry higher debt levels and also require greater fiscal adjustments, ie. increasing revenues or decreasing expenditures, to help stabilize their debt levels. The International Monetary Fund estimates that for developed countries, the size of the fiscal adjustment required between 21 and 22 to stabilize their debt at 6 of GDP by 23 is 8.8. For emerging markets countries, a fiscal adjustment of only 2.6 stabilizes their debt at a much healthier 4 of GDP. To fully appreciate this difference, it is helpful to look at the required fiscal adjustment by country and country groupings, shown here in Figure 8: Figure 8 Fiscal Adjustment (as of GDP) Required Between 21 and 22 To Achieve Debt Target by 23 18 16 14 12 1 8 6 4 2 Source of data: IMF Strategies for Fiscal Consolidation in the Post-Crisis World. February 4th, 21. The higher debt levels and high funding needs of the developed countries increase their risk profile, and these more worrisome debt dynamics make us less optimistic on the outlook for growth in the developed world. Greece is the most recent poster child of fiscal profligacy and problematic debt dynamics in developed countries. Greece is in the headlines now because of its high fiscal funding needs combined with large amounts of outstanding debt that must be rolled over. However, as shown in the graph above, Greece is not alone in this regard. Emerging markets countries, on the other hand, are less likely to suffer from refinancing difficulties, leading to more promising and predictable growth. 5
The Impact of the New World Order on the Fixed Income Markets The fiscal and policy differences between emerging and developed countries, and the divergent results they have produced, have been closely watched by the fixed income markets. What are fixed income investors doing in response? Quite simply, the fixed income market is repricing the relative risk of developed markets and emerging markets debt. We can see this in Figure 9 below, which plots the basis point spread over US Treasuries (risk premium) that investors required to own a five-year credit default swap of each sovereign country a year ago versus what they demand today. As the chart depicts, the perceived risk of the debt of emerging markets countries has declined over the past year, with some, such as Hungary, Turkey, and South Africa, declining quite significantly. In the United States, perceived risk has risen slightly, although admittedly US sovereign debt remains the benchmark. The important point is that the credit markets are suggesting that the world is in transition and that there are better prospects outside of the US and peripheral Europe for fixed income investors. bps Figure 9 A World in Transition: Better Prospects Outside of the US and Peripheral Europe (5-Year CDS) 55 5 45 4 35 3 25 2 15 1 5 Emerging Developed Year Ago Current Source of data: JP Morgan Emerging Markets Outlook and Strategy. As of February 12, 21. Another factor to consider is that the credit quality of emerging markets countries is generally on an improving trend. So far in 21, there have been 18 positive rating actions (upgrades in ratings and upgrades in outlook changes) from the major rating agencies for emerging markets sovereigns, in contrast to only three negative rating actions (downgrade in rating and downgrade in outlook for the same group). (Source: JP Morgan, through March 16, 21) We expect this trend to continue, further supporting the improving prospects for emerging markets debt. The Sustainability Question For these reasons, we believe the current repricing of emerging markets sovereign debt is sustainable. Not only are the fundamentals of emerging markets countries superior, but the technical outlook is also positive: there is strong and growing demand for emerging markets sovereign debt. Strategic allocations to emerging markets debt by pension funds, sovereign wealth funds, and individual retail investors continue to grow. As Figure 1 below illustrates, private capital flows into emerging markets, which include equity capital and foreign direct investment as well as debt inflows, have picked up so far in 21 after declines in 28 and 29. 6
Figure 1 Emerging Market Private Capital Inflows (198-21) Source: IIF Capital Flows to Emerging Market Economies, pg 1. As of January 26, 21. Shown with permission. We and others expect this trend to continue. Inflows into emerging market debt alone are expected to range between $4-$45 billion in 21. (Source: JP Morgan. As of March 11, 21.) A final factor is that emerging markets countries still have an important ally in the International Monetary Fund (IMF). Emerging markets countries that are members of the IMF, and that in general have sound policies or a reasonable willingness to make the changes necessary to get their finances on a more sustainable path, have access to different kinds of attractive funding from the IMF. As such, the IMF provides emerging markets countries with a backstop of sorts, so that in the event of another global shock, financing is likely to be available to avoid or contain a crisis. Of course, since the G-1 developed countries provide funding for the IMF, emerging markets countries cannot rely exclusively on the IMF indefinitely. For now, however, it remains a welcome support. Risks Do Exist, Of Course We do not mean to imply that emerging markets countries will be completely immune to crises emanating from G-3 countries. Fundamentally, a sharp drop-off in G-3 economic growth would reduce emerging markets exports and would also hurt the value of emerging markets investments in G-1 countries. Emerging markets countries, although they are clearly and steadily becoming less vulnerable to external shocks for the reasons outlined above, would still be affected in such a scenario. As such, while the long-term returns of emerging markets debt should be less correlated with developed markets, short-term risks could still be correlated to some extent. Implications for Fixed Income Investors What does this mean for fixed income investors? The current well-publicized troubles of a developed country like Greece illustrate the dangers of over-borrowing and under-saving and investing. Indeed, we believe the long-term sovereign risks now present in some developed countries reach beyond government bonds. Should one of these countries endure a severe and extended crisis, the risks are likely to quickly spill over to the country s banks and to many of its large corporations as well. Emerging markets countries, because of generally stronger fiscal and debt management policies over the past several years, can now be considered stronger from a fundamental standpoint than some developed market countries. Importantly, this trend is expected to continue. Such strong fundamental underpinnings, particularly in the debt management area, go far in mitigating the risk of owning emerging markets sovereign debt. 7
The fixed income market clearly recognizes this. It has begun adjusting its understanding of the current relative risk between emerging and developed countries, and is starting to reprice sovereign debt accordingly across the globe. Importantly, this repricing has been broad-based, with the emerging markets debt sector now offering multiple and increasingly robust channels for investment, including local market instruments, currencies, and corporate debt in addition to dollar-denominated sovereign debt. Local market instruments offer higher real yields currently as well as the potential for long-term foreign exchange appreciation tied to GDP growth. Furthermore, some of the largest issuers of corporate bonds in the world are domiciled in emerging markets: think Cemex, Reliance, Petrobras, and Gazprom, to name a few. In summary, we expect the ongoing improvement in emerging markets country fundamentals, along with the current powerful technical backdrop, to continue to support tighter spreads and solid performance in the emerging markets in 21. 8
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