BlackRock: Where next for emerging market debt?

 
Sergio Trigo Paz
Cyclists ride the quiet streets of Beiji
Emerging market debt has had a strong start so far this year. Hard currency sovereign debt returned 3.38 per cent and local debt is up 4.62 per cent in US dollar terms (Source: Getty)

Emerging market debt (EMD) has matured as an asset class, with a growing number of investors attracted to the increasingly positive economic fundamentals and higher yields.

EMD also offers an expanding opportunity set with plenty of diversification opportunities. That said, the asset class comes with distinct risks that makes achieving relatively stable returns in the shorter term no easy task. The answer, we believe, involves a different approach to asset allocation and selection, and access to the right technology to undertake risk management in real time.

Moving beyond the traditional

Traditional fundamental top-down and bottom-up active management approaches can be inadequate during regime changes or when unexpected events roil markets. It is therefore not enough to implement a static asset allocation between local, hard and corporate debt based on historical data and to then try to achieve optimum timing.

To take fuller advantage of the asset class, a more forward-looking investment approach that takes into account EMD’s distinct characteristics is required, even more so now. Performance drivers have become more numerous and complex, just as the investment environment in fixed income is increasingly challenging following a 35-year bull market. Central bank support is now waning and investors may be left over-exposed to monetary policy risks.

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This suggests that further diversification away from core developed market fixed income is set to be crucial. In this context, EMD stands out as one of the few remaining places where investors can find investment-grade yield that offers some protection against the impact of rising interest rates. So despite perceived headwinds following Donald Trump’s victory in November 2016, EMD has had a strong start so far this year. Hard currency sovereign debt returned 3.38 per cent and local debt is up 4.62 per cent in US-dollar terms as of 24 February, according to Bloomberg data.

Equally, though, this year’s buoyant performance also means that valuations are now more stretched. Therefore the ability to actively pick between the winners and losers will likely become a more important returns driver. Meanwhile, the transitions already underway could again disrupt global markets, including EMD, in 2017: an interest rate regime shift led by the Fed; a move from fiscal restraint to fiscal stimulus; or a move from globalisation to protectionism, to name a few.

The implications on EMD will differ from developed market fixed income, and accommodating for these differences is an important step to optimise opportunities.

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First, EMD is heavily influenced by global external forces that are in constant motion, making investment cycles more uncertain. Some examples include the normalisation of monetary policy in the US, China’s pace of economic growth, the direction of oil prices and the US dollar. All of them can impact significantly the performance and risk profile of EMD assets.

Second, the diversity of the asset class should mean more attendant alpha opportunities for investors, but the changing nature of the performance drivers make alpha generation less straightforward than it seems.

Finally, the asset class is particularly vulnerable to short-term surprises, as evidenced last year by November’s US elections.

Re-engineering the essential components

These differences can have an important impact on the three essential components of active management – asset allocation, selection and risk management – and not surprisingly, stretch many investors’ ability to extract more consistent returns from the asset class.

Consider groups of countries that may share commonalities impacting bond and currency performance when market conditions change. Central banks that are hiking rates, for example, can be separated from others that are more dovish, or highly-indebted economies versus low-leveraged ones. With this simple comparison, we can gain some information on how these groups would perform differently if, for example, inflows into EMD accelerate.

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Obviously, the actual implementation of such a view is far more complicated because the return drivers that affect the subsets of countries tend to vary in magnitude, frequency and length of time.

Identifying and understanding how potential changes in global and local drivers may impact each country or groups of countries in multiple ways has become essential. It is no longer adequate to invest in a particular debt issue based on forecasts or valuation models generated from historical data.

Managers also need clarity on how certain securities may perform under multiple conditions. What happens if the Fed raises interest rates faster than expected, or if the latest polls are wrong about the French presidential election? Then perhaps even more importantly, they need to have the technology and tools to interpret, quantify and efficiently manage the risks.

An investment process that is fit for purpose in today’s unpredictable environment needs to address EMD’s specific characteristics: next-generation active management if you will. In practice, it means adopting a dynamic asset allocation framework with risk parameters that can be adjusted swiftly for expected market shifts; selecting countries and securities through a forward-thinking lens and skilful use of scenario-based risk management.

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