Commentary: Emerging market debt deserves a seat at the table

Throughout my career, a lot of investors have remained skeptical about emerging markets. Concerns have varied, but they boil down to three key perceptions: that emerging markets deliver underperformance; that they aren't worth the risk; and that they're home to bad politics and weak policymaking. In each case, a close look at recent reality gives cause to question these perceptions.

Let's start with politics/policymaking. At a recent talk I gave to asset allocators, I shared a couple of scenario-based quiz questions and in each case, I asked, is it an emerging or developed market?

Scenario 1: a central bank runs excessively loose monetary policy for 18 months despite U.S. monetary policy tightening. This causes the currency to depreciate by 30-40% against the U.S. dollar. A few people guessed correctly — this is a developed market (Japan). In aggregate, developed market currencies underperformed emerging market currencies in 2022 as the U.S. started hiking rates, and the Japanese yen was the prime example of this; emerging market economies were generally ahead of the hiking cycle, but Japan kept running excessively loose policy and maintained yield-curve control. As the Fed aggressively tackled inflation, the best option for asset allocators was to sell protected and over-valued Japanese bonds, and in turn the yen sold off.

Scenario 2: policymakers unveil an unfunded fiscal dash for growth, resulting in a 70% devaluation in local currency bonds. A few more people got this one right — the U.K.. Early in 2021, long-dated gilts traded at par; now they're around 30 pence to the pound. At the same time, sterling fell to parity with the U.S. dollar; a dollar investor owning long-dated gilts lost about 80% of their mark-to-market value at one stage. From my experience in trading in debt markets, these types of moves would typically be reserved for emerging markets rather than what were once considered safe-haven markets.

Beyond these extreme scenarios, policymakers across emerging markets — with exceptions, of course — have proven their orthodox credentials in various ways over the past few years. This is evidenced in proactive rate hiking: when inflation turned up in emerging markets, central banks hiked; when it turned up in developed markets, they called it "transitory." It is also seen in fiscal prudence by emerging markets policymakers, even as inflation spurred nominal growth — resulting in primary fiscal balances being in surplus across many emerging markets economies in 2022 and debt-to-GDP stabilizing at modest levels. After more than a decade of unconventional policy in developed markets, emerging markets economies stack up considerably better across many fundamental metrics.

And it's not just through a policymaking perspective that the lines appear to be blurring between emerging and developed markets. Let's consider the perception that emerging markets are not worth the risk. Looking at a 20-year time frame, we consider the preferred local index for emerging markets debt — the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified, which includes 20 countries and currencies. For developed markets, we use the J.P. Morgan GBI-Broad index. From this we measured the seven largest developed bond markets with different currencies to best represent asset-owner portfolios. Both indexes are unhedged in U.S. dollars, and we have also removed any duration bias by using the five to seven-year bucket for each index. As Figure 1 shows, emerging markets debt market volatility — naturally higher than developed markets — has not really changed throughout the bond market turbulence of the last few years. But developed markets debt appears to have broken out of the last decade's calm and entered a new regime — with markets like U.S. Treasuries, U.K. gilts and the Japanese currency exhibiting significant volatility. While developed bonds still have much to offer investors as a defensive core allocation, in this uncertain world of heightened volatility, it is not emerging markets debt that has changed, it is developed markets.

Finally, turning to performance, Figure 2 considers the same time frame and opportunity sets as Figure 1 and reveals two contrasting decades. In the first, emerging markets performed well except for a blip during the global financial crisis. The following decade has been much more challenging, with taper tantrum and relentless U.S.-dollar strength both significant drivers of this. But that dynamic has begun to shift. On a rolling annual basis, emerging markets bonds have recently started to outperform developed markets again.

The simple explanation for this is strong fundamental foundations. From 2013 to 2016 (taper tantrum), many emerging markets economies addressed the imbalances that had weighed heavily on returns; more recently, proactive monetary policymaking put emerging markets economies on the front foot in tackling inflation. The contrast with developed markets central banks is stark. When thinking about the next decade, we think it's the first of the two considered above — rather than the most recent decade — that is more useful to guide expectations. Asset allocators should ask whether the tide has turned on emerging markets underperformance.

To sum up, there is some telling evidence that suggests it is not emerging markets that have changed, but distinct regime shifts are happening in developed markets to cause a blurring of the lines between the two. We think this warrants a rethink of the common perceptions impacting emerging markets debt allocations; this is an asset class that deserves a seat at the table.

Peter Kent is co-head of fixed income at Ninety One, based in Cape Town, South Africa. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.