The frontiers of diversification: a deep-dive into emerging markets

ARTICLE

THE FRONTIERS OF DIVERSIFICATION: A DEEP-DIVE INTO EMERGING MARKETS

By Michaël Vander Elst,
Fund Manager EMD at DPAM

Foreign investor positioning in local currency markets is currently at multi-year lows, offering an excellent investment opportunity. Since the taper tantrum in 2013, investors have been disappointed by returns in this asset class. A reduction of the risk premium (i.e., lower yields and spreads) for most of this period was accompanied by negative foreign exchange returns, resulting in poor overall returns. Going forward, this might change as EMFX returns will most likely be positive. Emerging markets need to have a positive real-rate buffer vis-a-vis developed markets to keep FDI flows in the country and to preserve the value of the currency (see gray bars in the graph below representing the real rate differential). During the COVID-era in 2020/2021, this real rate buffer has been below historical levels (around 1.50-2.00%). Being close to zero, or slightly negative, around the middle of 2021, many emerging market central banks acknowledged the risks and started hiking well in advance of developed market central banks. The unprecedented hiking cycle that followed restored the historical real rate buffer, which persisted even following the commencement of monetary tightening in developed markets¹. With more clarity on the FED’s terminal rate now priced into markets, the US dollar strength is likely to recede, which in turn will support emerging market currencies.

Figure 1: emerging market – developed market real rate differential

Source: JP Morgan, Bloomberg, DPAM – Developed markets include US, Eurozone, Japan, UK, Switzerland, Canada, Australia and New-Zealand

With inflation peaking and economic activity slowing down, many emerging market central banks will have room to ease rates in 2023. Expect a rather cautious stance, leaving rates higher for longer (eventually waiting for the FED to terminate its cycle), especially in countries where fiscal policy is expected to remain loose (e.g., Brazil, Chile, …).

Absolute yield levels in emerging markets sovereign are at multi-year highs. With yields in these strategies above 8.25%, this translates into a 70bp monthly carry. Alternatively, the carry allows the investor to withstand a 1.50% rise in yields before realising a negative return on a 12-month time horizon².

Cheap valuations, high carry, supportive currencies and low foreign investor presence: the stars are aligned for a brilliant 2023. For those with doubts on the EMFX part, a hard currency sustainable strategy can be envisaged. With the rise of US yields, spreads over US government are not at all time high levels, but from an absolute yield level it offers great value.

Near simultaneous health (COVID), food, and energy crises (Ukraine) have impacted the fiscal metrics of many emerging countries. Even commodity-rich countries have barely benefited from a spike in prices, as extra revenues had to be used to subsidise the poorer part of the population. In combination with tight funding conditions throughout 2022, long term debt sustainability might become an issue. Some countries might default and investors in local currency are not always better protected than investors in hard currency³. Proactive funding strategies, including the use of concessional sources and improved management of local market borrowing, should reduce liquidity risks. More and more countries are utilizing the Resilience and Sustainability Facility offered by the IMF to low- and middle-income countries, to promote climate change and pandemic preparedness.

The global diversification of the asset class offers investor the best protection against unforeseen circumstances such as geopolitical tensions and pandemic risks. Along with the growing importance of emerging economies in global trade, this is probably the most compelling reason to be overweight emerging market sovereign bonds.

We also believe that adding a sustainable layer to the investment process adds another dimension of analysis. Indeed, weak institutions and a polarised government can have an important impact on macro-economic performance and even affect the likelihood of defaults on sovereign debt as demonstrated by Rong Qian⁴. Sovereigns must make the needed investments to develop the Environmental and Societal parts of ESG. Concentration of power in the hands of one or few persons (or lack of Governance) will conflict sooner or later with the broader needs of the population. That is the reason why the exclusion of non-democratic countries is crucial (e.g., Russia in 2022). Given the high correlation between countries with a high E, S, G score in the model and their overall financial rating, our approach to invest at least 40% of the assets under management into the top 25% of countries in the ranking, creates a quality bias, has a positive impact on volatility, and limits drawdown risk for the investor⁵.

^[1]Source: JP Morgan, Bloomberg, DPAM – Developed markets include US, Eurozone, Japan, UK, Switzerland, Canada, Australia and New-Zealand.
^[2]For a modified duration of around 5.50.
^[3] For instance in 2022, Ghana defaulted both on hard- and local currency debt. Egypt did not default but depreciated its currency by more than 30%.
^[4]Source: R Qian – Why do some countries default more often than others? The role of institutions (March 1, 2012, World Bank Policy Research Working Paper).
^[5] Maximum drawdown since inception in EUR terms and calculated by full calendar year is at -1.96% (2015).

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THE FRONTIERS OF DIVERSIFICATION: A DEEP-DIVE INTO EMERGING MARKETS