FOR PROFESSIONAL CLIENTS AND IN SWITZERLAND, QUALIFIED INVESTORS ONLY Understanding risk return in EMD local currency July 2017 Increased interest in emerging market (EM) assets is set to continue due to investors anxious search for yield and returns, says economic consultancy Llewellyn Consulting in a recent paper commissioned by BNY Mellon Investment Management. The paper, Policy: The road to perdition or salvation? contends pressure will remain on EMs to liberalise their financial systems and offer a broader range of liquid, transparent and better-regulated securities markets, especially in the area of fixed income. Federico Garcia Zamora Federico is a director of emerging markets and portfolio manager responsible for managing investments in emerging market local currency debt portfolios at Standish. He joined the firm in 2012 from American Century Investments where he was coportfolio manager of the international fixed income, global fixed income and strategic inflation opportunities funds. Before that, he was a currency strategist and portfolio manager at Lehman Brothers Asset Management. Federico earned an MBA from Columbia Business School, a master s degree in finance from Universidad de Buenos Aires, and a Licentiate in Economics from Universidad Nacional del Sur. It continues: The shortage of global safe havens and trusted stores of value suggests that a particular area of international interest will be the sovereign, semi-sovereign and high-grade corporate debt markets of China and other more mature developing economies. While emerging market local currency could be considered one of the most volatile sectors of the fixed income asset class, it also has high return potential, says Federico Garcia Zamora, director of emerging markets at Standish 1, a BNY Mellon company. Undoubtedly, investing in an asset class with this risk-return profile requires a comprehensive understanding of the sources of risk and return. Executive summary The level of volatility in local-currency EMD gives it a risk profile that fits roughly between that of the US High Yield Corporate Index and the S&P 500. Strong tailwinds exist for the asset class to continue to show strong performance over the coming quarters. In the 15 years following the 1997 debt crisis in Asia and Russia, the influence of carry diminished as the creditworthiness of many EM governments improved. While currency may appear to feature a relatively inefficient return per unit of risk taken, an investor who takes the volatility from EM currencies can also enjoy the benefits of the positive carry. Many EM countries have close commercial ties with the EU and as such the EUR/USD exchange rate is critically important. 1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.
There is no denying emerging market debt denominated in local currency has been very volatile over the past few years. After falling by 33% in US dollar terms from May 2013 to January 2016, the asset class has rebounded strongly since and is now attracting renewed interest from global investors. Over its history -from 2003 to 2016 -its annualised return, as measured in US dollar, is 8.34%. Over the same period, it has also recorded annualised expost volatility of 12%, as well as rolling three-year annualised volatility between 8% and 16%. 2 That level of volatility gives the local-currency EMD a risk profile that fits roughly between that of the US High Yield Corporate Index and the S&P 500. Investing in an asset class with this risk-return profile requires a comprehensive understanding of the sources of risk and return. We believe there are three main components that can be used to provide such an understanding: duration, carry and currency. Table 1: EMD local currency (USD) total return decomposition Annualized Return Annualized Volatility Worst Drawdown Return per Unit of Risk GBI EM Global Diversified Unhedged Index Total Return in USD Duration FX Carry 8.34% 5.08% -0.73% 3.87% 12.0 4.49% 9.16% 0.74% -29.32% -7.42% -45.23% -0.43% 0.70 1.13 (0.08) 5.24 Chart 1: Long term risk return profile for various asset classes 12% EM Equities 1 Embi Global Annual Return 8% 6% GBI EM USD Hedged Cembi Diversified US High Yield US High Grade Global Unhedged GBI EM Unhedged US Equities 4% Global Hedged US Treasuries 2% 5% 1 15% 2 25% Annual Volatility Benchmark returns from January 2003 through September 2016. 2 All raw data in paper from Bloomberg, calculations from Standish as at 30 September 2016. 2
Duration The duration component includes the return of local currency bonds after hedging out the currency risk using currency forwards. It can be thought of as the compensation for taking on interest rate and term premia risks exclusively. Historically, this component has contributed 5.08% to the return of the asset class, with 4.49% annualised volatility. These are very efficient results, even when compared to highly risk-efficient fixed income asset classes, such as US Treasuries and Global Aggregate hedged into USD. The rolling three-year volatility of the duration component has fluctuated between 3% and 7%, while the rolling one-year return has fluctuated between -5% and +15%. 3 As shown in Chart 3, where the trailing 12-month return has been plotted for this component versus that of the Global Aggregate USD hedged, the duration component is primarily driven by the direction of global rates: US Treasuries, German bunds, and Japanese JGBs. Domestic considerations for EM countries (such as inflation outlook, policy expectations, and sovereign risk) also matter at times but it is typically global rates that determine the overall direction of this component. Chart 2: Duration component, rolling volatility L36M Rolling Volatility 1 8% 6% 4% 2% Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Duration Component Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Chart 3: Duration component and global aggregate USD hedged L12M Rolling Volatility 2 15% 1 5% -5% -1 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Duration Component Barclays Global Aggregate USD Hedged Index Source: Standish, Barclays as of 30 September 2016. Carry The carry component captures the differential between money market rates in emerging markets and those in the base currency of the investor. Positive rate differential between emerging and developed currencies typically reflect differing inflation paths and credit quality between emerging and developed economies. For example in 1997, a wave of devaluations across Asia and Russia boosted the positive carry as risk premiums moved materially higher. In the following decade and a half, however, carry diminished as the creditworthiness of many EM governments improved, more flexible exchange-rate regimes reduced the threat of abrupt devaluations, foreign capital flowed in and policy rates were cut. More recently, declining commodity prices (among other factors) have slowed EM growth, capital has flowed out, currencies depreciated, and EM central banks were forced to hike rates to fight inflation. As a result, carry has risen again. As at November 2016, the positive carry in the JPM GBI EM Global Diversified Index was around 4.75% in US dollar terms. Historically, this component has contributed almost 4% to the total return of the asset class, with very little annualised volatility. The catch is that the only way you can have exposure to the carry component is by taking on EM currency risk, which takes us to the third and last component. Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 3 All raw data from Bloomberg, calculations from Standish as at 31 September 2016. 3
Currency This component captures changes in spot exchange rates in EM currencies versus the base currency. As seen in Table 1, this component is the single greatest source of volatility in local-currency EMD. Over the full history of the asset class (2003-2016), it has contributed relatively little to the total return with over 9% of annualised volatility. Rolling threeyear volatility has fluctuated between 6% and 12%, while the rolling one-year return has fluctuated between -25% and 2. While this may appear to be a relatively inefficient return per unit of risk taken, an investor who takes the volatility from EM currencies will also enjoy the benefits of the positive carry, as explained in the prior component. Therefore, the impact of currency on return needs to be considered in investment decisions not in a vacuum, but as part of a bundle. What is the source of volatility of this component? As shown in Charts 4 and 5, the currency component is driven primarily by two main external factors: commodity prices and the EUR/USD exchange rate. Many of the countries in the EM local currency universe are commodity producers and the prices of these commodities have major impact on their external and fiscal accounts. Also, many of the countries have close commercial ties with the EU and hence the EUR/USD exchange rate is critically important in the determination of the Real Effective Exchange Rate which in turn impacts their external competitiveness. As explained with the duration component, domestic considerations for EM countries also matter at times but typically these two external drivers are the main explanatory variables of the currency component contribution to the total return of the asset class. Chart 4 and 5: Currency vs EUR/USD exchange rate & commodity prices L12M Rolling Returns 6 L12M Rolling Returns 3 4 2 2 1-2 -1-4 -2-6 -3 Dec-03 Oct-04 Aug-05 Jun-06 Apr-07 Feb-08 Dec-08 Oct-09 Aug-10 Jun-11 Apr-12 Feb-13 Dec-13 Oct-14 Aug-15 Jun-16 Dec-03 Oct-04 Aug-05 Jun-06 Apr-07 Feb-08 Dec-08 Oct-09 Aug-10 Jun-11 Apr-12 Feb-13 Dec-13 Oct-14 Aug-15 Jun-16 FX Component CRB Commodity Index FX Component EUR/USD 4
Finally, the currency and duration components have historically shown positive correlation as indicated by Chart 6. Intuitively, the more volatile a nation s currency the higher the risk premium the local-currency bond market typically needs to offer. Also, both components are strongly influenced by, in the end, the same set of external and domestic factors as explained previously. The external drivers include monetary policy in developed countries, the rise or fall in the price of commodities (particularly oil) and expectations for growth in the global economy. The domestic drivers include expectations for domestic growth and inflation, as well as sovereign risk. Looking forward The return decomposition into duration, carry and currency helps understand the sources of the volatility of EMD local currency as an asset class. A good understanding of the factors that drive each of these components, we believe, is critically important to help forecast the returns of the asset class into the future. We believe the combination of (1) a high level of positive carry, (2) an attractive external environment, and (3) improving fundamentals in many of the countries that are part of the universe, provide strong tailwinds for the asset class to continue to show strong performance over the coming quarters. Figure 6: Relationship between currency and duration components FX Component (x axis) and Duration Component (y axis) have historically shown positive correlation. 8% 6% 4% 2% -15% -1-5% 5% 1 15% -2% -4% -6% y = 0.2748x + 0.0043 R² = 0.31449-8% 5
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