One area of the fixed income market we still see fundamental appeal is emerging market debt. This asset class has suffered following the Trump election with prices falling and yields rising. This provides us with a contrarian opportunity, as investors suffer from an abundance of misunderstandings and misconceptions.
For example, most people immediately think of structural risks in China and the impact it would have on emerging market growth. However, what most investors do not realise is that emerging market debt has very little exposure to China. For example, the most common local currency benchmark contains an insignificant exposure to China of just 4%, even in hard currency terms, China is still constrained to approximately 4% of the major index.
A Day in the Life of a Volatile Asset
This is not to say that sentiment towards emerging market debt won’t be impacted by China. To gain a better understanding of emerging market debt and its volatility, a simple take on the “day in the life” can be described below:
It starts in a healthy manner, paying a yield in the vicinity of 6%, around 3-5 percentage points higher than western world debt, to give it a buffer against expected turbulence.
By breakfast, it will know if it is having a good day or a bad day. Confidence levels will determine if there is enough liquidity in the market for investors to place their trades. By mid-morning, the currency traders are placing bets on the short-term direction. If sentiment is negative, the currency can create a double-impact against falling prices in local currency terms.
By lunchtime, emerging market inflation data is released. If it is too high, people worry. If it is too low, people worry anyway.
By mid-afternoon, the rating agencies knock on the door. If it looks like default risks are rising, the market demands a higher risk premium.
In the late afternoon, the western nations will open for business. If equity markets fall, emerging market debt tends to fall with it. In addition, any government or central bank policy releases can hit fiscal and monetary expectations and change the outlook on its head. As it lays with exhaustion at the end of the day, one can reflect on the various events. Most days it will survive, some it will flourish. But in many instances, it is a sentiment-driven ride for unknowing investors.
The Pragmatic Approach
We advocate taking a step back from all the volatility and consider two important concepts. Firstly, the key is whether the market is fundamentally cheap. This is an assessment of whether the yield is high enough to account for the higher default risk, illiquidity risk, inflation risk and currency risk. The second concept is to understand how to position it in portfolios. We need to think about sizing and ways to maximise the diversification benefits in such a manner that will ultimately reduce the risk of a permanent loss of capital.
What is the Intelligent Response Today?
Emerging market debt undoubtedly needs to be acknowledged as a less predictable part of fixed income markets. It has a higher yield, but the volatility risk is magnified. We challenge the notion that risk equals volatility in a long-term context, volatility may be higher, but the highest risk of a permanent capital loss is to invest in expensive assets, although it is nevertheless important to recognise the unique and sensitive nature of emerging market debt.
Perspective is king for an asset class with such sensitivity to changes in sentiment. Viewed from a long-term perspective, it is clear that emerging market debt looks cheap relative to most other fixed income options.
If one takes a step back and thinks rationally for a moment, it really doesn’t make sense for 16 emerging markets to collectively be 7% worse off under a Donald Trump presidency. Whether the reflation story is valid or not is incredibly complex and any judgements must have a large margin for error. The truth is that no-one knows what will happen to bond yields in the near term, especially in emerging markets, and anyone that pretends to portray knowledge are probably about to learn a lesson about the deficiencies of forecasting and short-termism.
Therefore, the best thing we can do is to focus on the fundamentals. The exact moment investors feel comfort is the time they should be getting nervous. For instance, investing in emerging market debt when confidence is extremely high – such as 2003-2006, 2010, 2012-2014 – tends to provide far riskier future outcomes than when bond markets appear shaken. At this stage, the market still appears to be positioned for outperformance relative to other fixed income assets.
