Emerging markets account for about 60% of the world economy and 75% of global growth – almost double their share two decades ago.
They also account for more than $2trn - or about a quarter - of the global fixed income market. Yet, despite the size and growing importance of EM, global portfolios have not reflected these structural changes, and investors are still largely underweight EM local bonds.
We think the shifting macroeconomic backdrop might contribute to a global rebalancing of investments that will favour allocations to EM. Actively managed EM strategies, in particular, could become increasingly attractive in this very low global rate environment.
The macroeconomic environment for emerging markets has changed significantly over the past two decades. Of the 19 countries in the J.P. Morgan GBI-EM Global Diversified index, 15 are investment grade.
Emerging market economies have gained experience in dealing with volatile and adverse global market conditions.
Policymaking is more orthodox, institutions have strengthened and policy efficiency has been enhanced. Crucially, most central banks are independent, and credible in their communications and in implementing policies.
Meanwhile, more flexible currencies provide a buffer against external shocks.
Now, some 80% of EM sovereign bonds are denominated in local currency. This has made fiscal accounts more resilient to global conditions and EM governments less reliant on external funding.
A changed composition of public debt has created more complete and extended local yield curves.
As local fixed income markets become deeper and more efficient, and increasingly driven by domestic factors, local EM debt strategies have also become increasingly attractive for global investors not only from playing interest rates through the carry trade, but also from a diversification perspective.
Moreover, the domestic investor base is broader and more stable. Local pension funds, insurance companies and mutual funds are the dominant players in these markets, having driven national treasuries to enhance local yield curves. They have also provided an efficient cushion during periods of volatility.
Local debt markets are not only the most liquid segment of EM fixed income markets (offering the lowest bid/offer spreads and accounting for 70% of the trading volume), but they are also the safest segment of EM assets.
Sovereign defaults in local currency have been rare. In fact, EM central banks have been proactive in supporting local bond markets.
In the recent Covid-19 crisis, at least 13 EM central banks started purchasing local currency bonds.
The BIS recently noted that these have helped restore investor confidence without undermining inflation expectations.
This shows, in our view, a very different macroeconomic landscape in EM, compared to the far weaker fundamentals only a decade or two ago.
Most emerging market economies entered the health crisis with improved debt dynamics and solid fiscal metrics. Furthermore, the global policy response to the Covid-19 crisis has eclipsed the ones of the past crises.
Covid-19 has pushed any 'normalisation' of global rates away to the horizon - bolstering the global search for yield.
EM debt currently offers around 4% yield pick-up to the dollar. Meanwhile, real EM yields are around 2.5%, compared to -0.86% for the US and -1.22 for Germany.
These spreads mean that EM central banks have scope to provide further easing, and to follow the descent in global rates. This reinforces the case for a structural long exposure to local EM duration.
Therefore, in the context of this 'lower for longer' environment, we expect to see a continuous rebalancing of global investments that will favour this asset class.
Of course, EM currencies exhibit high volatility, which necessitates active currency management - because understanding the sources of volatility is crucial to sorting winners from weak performers.
Our analysis indicates that many EM currencies remain undervalued.
At the same time, we expect the recovery of the global economy from the Covid-19 shutdown, and particularly China's resilience during this crisis, to cause the outlook for emerging markets assets should improve, leading risk premiums to be compressed.
Lastly, the gradual inclusion of China in global bond indices will significantly enhance the risk/return profile of the EM benchmark. The RMB bond market offers extremely low volatility, similar to DM, while providing relatively high yield.
Also, the increasing weight of China will gradually shift the weight of the index in favour of the more tech-oriented Asia.
Some of the most important factors that determine the outlook for emerging markets are global - from US-China relations to supply and demand in commodity markets - necessitating a top-down, active approach.
Local currency EM debt may well already be a core asset - so let's treat it as one.
The above article was originally published by Investment Week. https://www.investmentweek.co.uk/opinion/4019504/global-investors-start-upping-exposure-emd-assets
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