During the darkest days of the 2008/09 financial crisis, emerging market (EM) fixed income showed surprising resilience. From Poland to Mexico to South Korea, local-currency debt markets survived the storm relatively unscathed, buttressed by strong local institutions and sound policy decisions.
Taking notice, investors seeking yield and diversification in the developing world helped to propel the EM local debt to its current size of slightly more than US$1.5 trillion ($1.61 trillion)—many times bigger than the more familiar hard-currency debt market, according to J.P. Morgan.
Now, however, EM local debt has hit a crossroads. The waning of monetary stimulus in the United States has triggered a sharp price correction. The bellwether local debt index, J.P. Morgan’s Government Bond Index-EM Diversified Index, has fallen more than 9% (in U.S. dollars) over the 12-month period ending Apr. 30, 2014.
Notwithstanding that, we see encouraging and important signs for investors seeking strategic exposures to the secular EM growth story.
Significantly, in some of the more advanced emerging economies, the relationship of nominal GDP growth to local interest rates is beginning to resemble that of developed markets. With prospects for more locally driven business cycles, some EM local debt markets may be on the road to becoming truly local.
EM local debt markets are now hardwired into the world’s allocation machinery. Trading volumes of EM local debt reflect this new reality, as does the EM share of global currency trading, which climbed from 4.7% in 1998 to 18.7% in 2013, according to data from the Bank for International Settlements. EM local debt markets have received new flows from international investors of more than US$500 billion since 2009, notes Credit Suisse.
Local yield curves and flexible exchange-rate regimes now operate as automatic stabilizers for emerging economies. By absorbing shocks, they are reducing the volatility of real variables and smoothing the macroeconomic adjustment in countries that show unsustainable external or internal imbalances.
Viewed in this light, the recent correction in EM financial asset prices is not a problem. It is part of the solution.
As local markets continue to develop, we can expect local factors to become more important in the dynamics of local interest rates. This would imply that the business and credit cycles will become less dependent on the external environment and that the transmission channels of money policy can become more powerful, ultimately enhancing the links between nominal GDP growth and low interest rates.
Over time, the trend toward locally driven interest rates bodes well for greater economic stability in the developing world. It should also enable international investors to express a more nuanced view on the growth that EM assets have always promised but not always delivered.
New tools for asset allocators
The rise of local fixed income markets has already given asset allocators a new set of tools, enhancing their ability to construct portfolios with better risk-adjusted returns. Although correlations tend to be high between EM equities and fixed income, investors are starting to find new diversification opportunities across asset classes and local markets.
Country differentiation is digging deeper as well. Market drivers in different countries tend to be more local and idiosyncratic than ever before, from politics in Turkey, to the effects of China’s growth on commodity exporters like South Africa, to the credit cycle in Brazil.
Beyond short-term market movements, countries are increasingly being judged by the policy decisions that they make rather than factors outside their control.
As policymakers in some countries develop more credibility in setting monetary policy, there will be greater divergence with other risky assets as well as country by country. If growth is expected to accelerate in Mexico but flatline in Russia, for example, investors have more opportunities to differentiate between the two scenarios, both because of interest rate differentials and because of greater liquidity in debt instruments, interest rate derivatives and currency markets.
Near term, given uncertain growth prospects and rising rates, EM fixed income’s risks are all too apparent. Yet, with deepening differences among countries and changing dynamics in asset prices, opportunities should appear as well.
Conditions favourable for active, flexible strategies
Finding relative value requires both an understanding of the fundamentals and insight into local policy and currency markets. For those so equipped, the environment could be ideal for pursuing active and flexible investment strategies.
For EM countries, outcomes will depend largely on the capacity of authorities to adjust and adapt domestic policy tools. Those countries that rise to the challenge with sound policy choices stand to be rewarded.
As local markets have sold off since last May, investors should look for places in which confidence on policy-making is being restored.
The prospect of a new reformist administration and the possibility of inclusion in global fixed income indices make the high-yielding local debt of India an attractive proposition. Recent volatility in the currency and cyclical weakness of the Brazilian economy are providing a great entry point for investors that have the appropriate medium-term horizon. With five-year bonds offering 6% real rates and 12% nominal rates (according to Bloomberg data), combined with a central bank that has a credible inflation-targeting regime, relatively low debt ratios, we think Brazil local bonds should be a core holding for fixed-income investors.
Nigerian bonds have also become an attractive investment alternative. Now the biggest economy in Africa, Nigeria benefits from high growth, a current account surplus, ample foreign exchange reserves and low debt levels. According to Bloomberg data, the country’s five-year bonds offer a 12.99% yield, in a context of good market liquidity, a solid and well regulated financial sector and inflation under control around 8%.
Along with new opportunities for diversification and returns, we believe the development of local currency fixed income markets is providing emerging economies with a more solid macroeconomic backdrop. As local foundations continue to strengthen, we look for local business cycles to become the most important determinants of local financial asset prices.
This won’t happen overnight, and the transition will be neither uniform nor smooth. But over time, the more local rates come to reflect local economic conditions, the more attractive these markets will become to patient global investors seeking growth and diversification.
Gerardo Rodriguez, managing director, is senior investment strategist and business manager of BlackRock’s emerging markets group. Sergio Trigo Paz, managing director, is head of BlackRock’s emerging markets fixed income within its portfolio management group. The views expressed are those of the authors and not necessarily those of Benefits Canada.