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Commentaries

PMC Weekly Review - October 28, 2019

A Macro View: Casting a Wider Net

With literally hundreds of sources of news and information at our fingertips these days, it is easy for the average investor, and many investment professionals, to be overwhelmed by all of the data and opinions they are bombarded with every day. And yet, for all the information available to the US investor, very little focuses on opportunities outside of the US, and only a fraction of that is on emerging markets. But, in a period in which income is difficult to come by, emerging markets debt can provide a healthy yield boost to the average portfolio.

The emerging markets debt asset class consists of three major subasset classes: hard currency government debt, local currency government debt, and corporate debt. As the name implies, hard currency government debt is denominated in (and pays interest in) a currency other than that of the issuing country, primarily US dollars, though an increasing percentage of issuance is in euros. This has the advantage, for the US investor, of eliminating the currency risk and making the cash flows from the investment more predictable. The issuer takes on the currency risk, usually to gain a broader investor base outside of its home country. This can increase the cost of servicing the debt in the future if its currency depreciates against the dollar (or euro), which, in turn, elevates the possibility of default. Most countries also issue debt in the local currency for both domestic and global consumption. This places the currency risk (and potential gain) in the nondomestic investors’ hands. Emerging markets corporate debt is issued almost exclusively in hard currencies and largely noninvestment grade (given the much smaller size of the companies compared with the US market). For simplicity, we look at just the hard currency government market relative to the investment grade and noninvestment grade US market.

 

As of the end of the third quarter, more than 30% of the investment grade global bond market index  traded with a negative yield (primarily Japan and central Europe), and another 60% carried a yield between 0% and 3%, including the entire U.S. Treasury curve. This obviously makes meeting even a 3%-per-year income goal difficult. However, the hard currency government debt index  had a yield of more than 5% on that same date. This was roughly 50 basis points less than that of the US high yield market, but more than 55% of the emerging markets index is investment grade, including 20% rated A or better. The noninvestment grade portion of that index yielded more than 7% at the end of the quarter, 150 basis points more than the US high yield market. The additional yield available in emerging markets is primarily a function of perception and investor demand, rather than expected compensation for higher risk. Over the last ten years, that index has been only slightly more volatile than the US high yield market (a standard deviation of 6.15% vs. 5.86%).

But long-term investments should not be made on the basis of yield alone, and there are several compelling, fundamental reasons to be interested in the asset class. Economic growth across emerging markets economies has consistently been stronger than for developed economies over the last five years (even when excluding China), and the IMF projects that trend will continue for the next five years. Most emerging markets countries have growing labor forces (compared with stagnant or shrinking labor pools in developed countries), with significant room to improve labor productivity—improvements that already have been implemented elsewhere—resulting in higher real GDP growth. These economies, for the most part, also have used this economic growth to strengthen their “balance sheets,” running positive current accounts and keeping their national debt-to-GDP ratios in the 40-50% range, compared with an average ratio of more than double that for developed countries. Finally, current valuations, in terms of spreads relative to Treasurys, are slightly wider than the long-term averages, leaving room for further capital appreciation over the next few years in addition to the higher income.

This is not to say there are no risks lurking on the emerging markets debt horizon. The largest risks hanging over these markets in the last 18 months, the US/China trade dispute and whether Britain will leave the EU, have started to see some resolution in the past month or so. But neither is completely resolved, and a reversal in the progress would certainly have a negative impact on the market. An unexpected drop in developed markets growth or an overreaction by the various central banks also would put a damper on emerging markets bonds. And there are most definitely country- and region-specific risks that must be carefully navigated, as Argentina’s debt market showed us in August. Overall, there is much to be positive about in emerging markets bonds, both as a source of higher income and longer-term capital appreciation, as an addition to a diversified portfolio.

 

Nathan Behan

Sr. Investment Analyst

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