Local stories dominate EMD opportunities
Will emerging market debt (EMD) hold any appeal in 2014 considering the outflows seen in 2013?
People need income in their portfolio, and are looking to diversify away from the likes of the US, the UK, and Europe, so they can look towards emerging markets. These countries have a lot of appeal but people want to invest while also minimising risks.
In 2013 there was volatility concerning the potential impact Fed tapering may have; with tapering now under-way these concerns will continue.
We think people are perhaps a little more worried than they need to be about emerging markets. We don’t think there will be a rip-roaring recovery but likewise, looking at the data, it will not be too weak either. We expect there to be a slight upturn in economic growth over the next six months. It’s then a case of where to look for value. It could be a mixed bag through duration, rates and currency. Over the past few years, there were some pressures on emerging markets credit spreads, so people just bought debt. It’s important to remember that there are more than 70 countries which will have to deal with very different circumstances – we think it will come down to local stories. In Asia, for example, we think rates could pick up a little, while there could be improvements in Eastern European countries. Latin America, meanwhile, has a lot of different challenges.
What will drive EMD returns, aside from Fed policy?
Perhaps the biggest challenge for emerging markets is that this year is an enormous election cycle, with several important countries taking to the polls. Different governments respond to this in different ways – some, for example, tend to spend a lot before elections. We have to look at each different country and see how they deal with individual scenarios. Elections are the big issue, but also politics. The global cost of money is another factor to examine. There could be continued easy monetary policy throughout Europe and Asia, which is typically supportive of risk assets in general – including EMD.
Are you likely to avoid countries with elections coming up next year?
If we think the electoral processes in a country might cause difficulties then that is important to bear in mind. Typically, before elections people spend more money, which can lead to inflation and other negative side effects.
In Brazil, which is due to have its presidential elections in September 2014, there is an uneven distribution of wealth among its population. Its middle class has been rising but now it has become squeezed, which is why we see protests happening in the country. People see vast spending on things like the World Cup and the Olympics, but not enough is being done to help with the cost and quality of, for example, public transport – which can be a catalyst for protests.
For a long time Brazil was held up as a regional example of how public policy should be run, but lines seem to have blurred in recent times. There was muddled policy from the central bank, GDP figures which came as a negative shock and rising inflation with weaker growth caused dissatisfaction among squeezed workers. Meanwhile Mexico let its currency weaken and as a result is in a better position.
I think all of the BRICs (Brazil, Russia, India and China) have their challenges, but it’s actually in the next largest size segment of emerging market countries where we see better structural stories coming through.
What other political risks might appear?
I think we have got to keep an eye on the Middle East. It’s a positive that relations are improving between Iran and the US but there remains the potential for flareups. In China, the new political regime seems to be steady for the moment – and it’s interesting to see it has publicly fired and prosecuted members of the government in corruption cases. In Latin America, recent polling in Argentina points to a potentially positive transition. It will be interesting to see how many of the current president’s supporters change allegiance.
A big issue for bond markets is that some countries issued bonds very cheaply over the past year, but what happens if interest rates go up in 2014? It is also important to keep an eye on countries employing protectionist tactics, as that is when regional differences flare up. There could be problems with some countries in ‘frontier’ markets which have borrowed a lot of money. There are certain countries in Central America, for example, which have borrowed in US dollars but have revenues in local currency. What if these local currencies suffer a sell-off? Also, if some of these countries were borrowing to support infrastructure projects, then it would be fine, but many are borrowing on financial markets simply because they can. Will they always be able to pay this money back?
What will likely be more attractive: EMD in US dollars, or local currency denominations?
In each country, we look at where is the best risk to reward – local or external? I think in dollar denominations there’s a lot of value in corporates. In local rates, currencies are far more mixed because some will be weaker than others. Having said that, we don’t segregate – our portfolios take a blended approach, searching for whichever sub-asset class offers the best value.This is not investment advice. Regulatory Disclosure