Emerging markets. For mainstream investors, the term evokes memories of the past, when many of the largest countries in the emerging world experienced bouts of volatility, elevated borrowing costs, currency devaluations, high political risk and episodes of default. Debt levels were generally viewed to above-sustainable levels, clouded by high fiscal deficits and low growth prospects.
Does this sound familiar today? Well, it does when we assess the credit quality in developed countries. Yet investors are hardly getting compensated for such risks when investing in developed country government bonds, unless they can justify negative real rates. In contrast, emerging market debt levels have been on a declining path over the past decade and are generally expected to decline further in the coming years, according to International Monetary Fund forecasts. Valuations on emerging market sovereign bonds are arguably more attractive, too, with yields of about 6% on external debt and 6.5% on local currency debt, and should continue to offer appeal in the “lower for longer” environment.
Much has been said and debated about the debt, fiscal and growth outlooks in the developed world. In a word, they are deteriorating. Meanwhile, the outlook for emerging countries is pretty solid. Leaving aside the outliers such as Hungary, Egypt and Ukraine, default risk is currently as low as it has ever been. Average emerging market sovereign ratings are now investment grade, yet the underlying ratings clearly understate default risk.
Can we say the same about developed country ratings? Not a chance. The rating agencies are always going to be behind the curve, but let’s give them a bit of credit for downgrading the “safe havens” such as the U.S. and France while maintaining the respective negative outlooks. And there are more of these in the pipeline, as the negative feedback from high debt, fiscal deficits and low growth prospects takes its toll on credit quality. This is a role reversal of sorts, as a decade or so ago it was the emerging world that was blighted by similar risks. There were defaults back then, and there will be defaults once again—only this time, it will be developed countries facing the inevitable outcome.
