- Emerging markets have dramatically re-priced in recent years.
- It can be tempting for investors to see the emerging market asset class as a risk allocation.
- In fact, we see a wide range of choice within this asset class and believe the recent weakness presents an opportunity.
Few global asset classes have experienced the same level of risk re-pricing as emerging market (EM) local currency bonds over the last three years. The yield on the asset class relative to a basket of developed market government bonds now stands at a six-year high, representing a pickup of 5.4%. Meanwhile, EM currencies have weakened to such an extent that many of them now appear very cheap on a range of valuation measures. However, we believe investors should refrain from viewing the asset class as a potential beta allocation opportunity. Rather, they should seek to understand the varied dynamics of the small number of large countries in the opportunity set.
When assessing investment opportunities within emerging markets, we focus on understanding the direction of travel of fundamentals for each country. This allows us to understand which are improving and which are deteriorating. Our relative value models for local market instruments determine whether these fundamental changes, or expected changes, are reflected in asset prices.
Our investment case in Turkey, for example, is less favourable. The country is heading toward fresh parliamentary elections, as the process of coalition building following the June elections appears to be failing. Meanwhile, we believe the country’s financing mix is extremely risky. There are internal policy challenges that need to be resolved before we could become more bullish on local market assets. In Brazil, even though we believe that the government’s revisions to primary surplus targets for 2015 may present risks to debt sustainability, the market understands these risks better than those present in Turkey. Therefore, we would still consider holding Brazilian debt.
Meanwhile, the renewed slump in commodity prices continues to present challenges to those countries which rely on these products as a source of exports, government revenues or GDP growth. Any rebound in commodity prices - especially oil - would result in a more constructive view of fundamentals in Malaysia and Nigeria. Among oil exporters, we believe Colombia should perform well in the months to come. Its currency has undergone a drastic adjustment and we believe fiscal and monetary tightening is likely in the short to medium term.
Emerging markets have been subjected to extreme stresses in recent years: the ‘taper tantrum’, China weakness and the precipitous decline in commodity prices having created something of a perfect storm. In such a scenario, investors can be guilty of exhibiting insufficient discretion, choosing instead to view all EM countries as equal. For those willing to take a more nuanced approach, however, this creates opportunities. Sound fundamentals and coherent, responsible policy making are still on display among many EMs, and their local currency bonds offer an attractive level of income in today’s low-yield world.