Many investors deemed emerging markets too risky during much of 2015. But pension funds should consider increasing their allocations to debt, as 2016 could prove a better year for the asset class, says Luisa Porritt
2015 saw emerging markets face a perfect storm of factors that created headwinds for their economies. In turn, this sparked fears about the capacity of governments and corporates alike to repay debt.
China’s growth slowdown; the collapse of oil and other commodities prices; and, until recently, uncertainty surrounding the timing of a US Federal Reserve interest rate rise; made investors feel jittery about lending to debtors whom they viewed as most vulnerable to these shocks.
The good news is that for some countries, the effects of these features may finally be bottoming out.
Investors willing to take a three to five-year view will be compensated for buying into weakness”
Investors willing to take a three to five-year view will be compensated for buying into weakness, as emerging market currencies which suffered through 2015 will likely start to appreciate again in the next six to 12 months, creating favourable conditions for local currency debt, says Tapan Datta, global head of asset allocation at investment consultants Aon Hewitt.
Against a backdrop of weaker energy and raw materials prices, countries prepared to reform their economies look best placed to achieve success in 2016, says Nick Price, portfolio manager of the Fidelity Emerging Markets Fund.
A renewed push to introduce structural reforms is both necessary and likely, says Jens Nystedt, portfolio manager and head of sovereign research at Morgan Stanley Investment Management (MSIM), citing recent electoral outcomes in Argentina and Venezuela.
Countries prepared to reform their economies look best placed to achieve success”
Goldman Sachs Asset Management (GSAM) is tentatively seeking opportunities in both countries. “While valuations look attractive, we recognise there is higher potential for volatility,” says Yacov Arnopolin, emerging market debt portfolio manager. Paul McNamara, investment director at GAM, says there is a price at which Venezuelan debt ‘makes sense’ but in Argentina’s case, positive changes expected from its change of government have already been priced in.
Monetary policy sign posting
Some think the clarity resulting from the long-awaited interest rate rise by the US Federal Reserve Board (the Fed) will work in the asset class’s favour.
James Barrineau, co-head of Emerging Markets Debt Relative at Schroders, says “a more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite.” Should developed market bond yields remain low, then “emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come”.
A more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite”
Sovereign balance sheet fundamentals generally remain favourable to debt investments. Rob Drijkoningen, manager of the Neuberger Berman Short Duration Emerging Market Debt Fund, says the overall credit quality of emerging market sovereign debt is supported by strong public sector balance sheets, low external debt ratios and flexible exchange rate regimes.
Salman Ahmed, global strategist at Lombard Odier Investment Managers, notes that none of the countries are near default, as emerging market governments have allowed currencies to depreciate by 40% overall to avoid this prospect.
Opinion is divided on how conducive growth will be to the asset class in 2016.
“It is worth remembering that the rate of emerging markets growth is expected to be almost twice the rate of advanced economies next year, bolstered by the fact that sharp negative contributions to growth from Brazil and Russia will potentially ease,” says Nystedt at MSIM.
Steve Cook, co-head of emerging markets fixed income at PineBridge Investments, says that while Russia rebounded during 2015, following the Ukraine crisis and sanctions, the firm is less convinced that Brazil, clouded by the Lava Jato corruption investigations, will recover in 2016. “Investors tend to underestimate the complexities of vested interests of political players [in Brazil],” says Zsolt Papp, emerging market debt chief client portfolio manager at J.P. Morgan Asset Management (JPMAM).
Weaker growth and the poor performance of local currencies also affected the health of some corporates during 2015”
Kommer van Trigt, portfolio manager of the Robeco Global Total Return Bond fund, says the firm is still limiting its exposure to emerging market debt overall following the Fed’s rate hike, “in the light of the meagre growth outlook and deteriorating credit quality in most emerging economies”.
David Rae, head of LDI Solutions for EMEA at Russell Investments, says while opportunities exist from a valuation perspective, the catalysts needed to outweigh risks are unclear.
Weaker growth and the poor performance of local currencies also affected the health of some corporates during 2015. After a third successive year of sub-par average growth across emerging markets, non-performing loans could increase, warns Papp at JPMAM.
But some managers are finding opportunities among corporates. Cook at PineBridge says despite expectations for further currency weakness in 2016, the firm expects Chinese investment grade corporates to cope well as the property market continues to recover off the back of supportive government policies. They also like South African corporates, having witnessed a sharp sell-off as changes took place at the country’s finance ministry.
Active management approach
Given the complex macroeconomic drivers affecting emerging markets, and differences in regional and industrial trends, several analysts emphasise a selective approach.
Ahmed at Lombard Odier says that unlike in 2010, today the emerging markets universe is heterogeneous. The fall in commodities prices is positive news for importers, while being harmful to exporters, for example.
GSAM favours the Dominican Republic as an oil importer, although it has added exposure to countries such as Colombia, where it believes valuations have adjusted, says Arnopolin.
India is a darling in the eyes of several fund managers”
India is a darling in the eyes of several fund managers. Nystedt at MSIM says assuming China avoids a hard landing in 2016, there is value in both Indian and Indonesian external and domestic sovereign debt. McNamara at GAM thinks Mexico and India are better positioned in the current macroeconomic environment than South Africa and Brazil. According to Papp at JPMAM, India is fairly insulated from factors affecting emerging markets as a whole since its economy is more domestic demand-oriented.
Amid these divergent dynamics, Ahmed at Lombard Odier says investors need to be proactive in understanding drivers affecting particular countries. This means going beyond the basic assessment of market capitalisation by looking at socioeconomic imbalances, political instability, and factors affecting countries’ terms of trade.
PineBridge has its corporate and sovereign teams work together, combining top-down and bottom-up fundamental credit views to reach investment decisions on a universe of more than 70 countries and almost 400 companies.
For many other pension funds, allocating to emerging market debt is not an easy task”
Multi-employer defined contribution scheme NEST is procuring an actively managed pooled emerging market bond fund that includes debt denominated in both local and hard currencies. “We believe an active management approach can take advantage of opportunities while managing the portfolio risk by avoiding unattractive or risky borrowers,” says Mark Fawcett, the scheme’s chief investment officer.
For many other pension funds, allocating to emerging market debt is not an easy task. Those invested in multi-asset funds may already have some exposure, making overall exposure difficult to gauge, says Datta at Aon Hewitt. Schemes using that approach are meanwhile not necessarily well positioned to build exposure in a way that allows them to respond tactically to market changes, though it could provide a pathway to understanding the asset class, he adds.