28 March 2018, 12:26 GMT
If you were to ask Alexa, your virtual assistant, which Emerging Market Debt (EMD) asset class offers the best risk / return prospects, what would she say right now? Should you invest in external credit markets, looking for spread convergence through improving sovereign and corporate balance sheets? Or should you delve into the world of local currency debt, taking EMFX and local duration risk while speculating on the outlook for monetary policy and inflation?
Looking back over the period since the financial crisis, the yield on the EM local benchmark has almost always been above its sovereign and corporate external debt equivalents, averaging +0.75% of additional carry. Yet the picture on an annualised US Dollar total return basis over the same period points to a substantially superior outcome for sovereign (+9.5%) and corporate (+9.2%) external debt versus local markets (+6.7%). Adjusting for volatility and the equivalent risk-free rate, the Sharpe ratio on sovereign (+2.0) and corporate debt (+3.3) has been even more impressive when compared to local markets (+0.7), further enhancing the investor experience.
The story so far in 2018 illustrates the nuances of the three markets. EM sovereign external debt has lost -2.2% in total return YTD as this high duration asset class has suffered heavily from rising US Treasury yields. Conversely, local markets have returned +4.5%, with the persistently weak US Dollar providing the main tailwind. The shorter duration EM Corporate market meanwhile, sits in between with -1.3% total return.
Where do we go from here?
Overall, we are cautious, seeing limited opportunity for external sovereign spread compression at this late stage in the credit cycle while also mindful of growing fiscal risks. For us, the best sovereign value lies in high yielding but improving single B-rated countries like Argentina, Ecuador, Angola and Ivory Coast. We also prefer corporate debt to sovereign credit particularly in specific sectors such as Brazilian protein, Ukrainian metals & mining, African telecoms and Argentinian utilities.
On the local market side, the outlook is equally challenging. In our view, the US Dollar is overdue a rebound as the FOMC (Federal Open Market Committee) continues to respond to US economic health with tighter monetary policy and a reduction of its balance sheet. In local duration, we see the best value in inflation-linked bonds as price pressures grow across EM, driven by closing output gaps, rising energy prices and the fading benefit of benign base effects from the past two years. Attractive opportunities also exist at the front-end of frontier local markets like Nigeria and Egypt, with generous nominal yields and stable FX regimes.
Despite our cautiousness around global central bank liquidity withdrawal, we believe EMD still offers good relative value compared to the wider Global fixed income universe. EMD remains structurally under owned considering EM’s contribution to global growth, while EM’s external balances have vastly improved in recent years and the real yield cushion on local markets is considerable when compared to DM peers.
Against this complex backdrop, we believe Alexa’s response should be to recommend gaining a balanced exposure, with flexibility to switch between the different EMD asset classes. Moving away from traditional benchmark indices towards a total return approach can also help to capture alpha, while minimising the drawdowns typically experienced by the benchmarks.
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