Though certain factors like U.S. unilateralism and protectionism may cloud the global trade outlook, looking ahead we believe the next major shifts in global trading patterns to come from within the emerging markets themselves, excluding China.
But growth in domestic emerging markets investors has changed the dynamics of emerging markets debt as an asset class — an ongoing development potential investors should watch closely. The reorientation toward a more domestic buyer base has been driven in part by memories of the 1990s balance of payments crises, when adverse currency moves had a negative feedback loop on hard currency debt stocks. Emerging market countries want to avoid this problem by funding themselves domestically, thereby removing currency mismatch risks and reducing their reliance on foreign investor flows.
This shift has also been driven by an ongoing deepening and maturing of domestic financial systems with the growth of domestic pension funds, asset managers and banks, which provide demand for local currency debt. This development brings reduced volatility as local capital tends to be considerably more stable than foreign capital.
However, this does vary by region. Looking at the emerging markets corporate debt market, local investors tend to be more prominent in Middle Eastern and Asian markets, while offshore fund investors tend to be found in Latin America and emerging European countries.
Emerging market debt risk-adjusted returns have traditionally been attractive in hard currency, meaning that those looking toward the asset class should consider that while local currency debt (unhedged) can at times generate some of the strongest outright returns, it can also be the most volatile subasset class leading to a low Sharpe ratio.
Deconstructing local currency returns between spot foreign-exchange performance and bond performance shows that foreign exchange has been the most volatile of returns, and has been a consistent source of negative return in most of the asset class' down years. Given this, the structural rationale of investing in emerging market economies as they improve over time has less relevance for this segment of the asset class, although it does potentially offer compelling tactical opportunities.
Down the line, changes in U.S. interest rates and the fluctuating strength of the U.S. dollar will almost certainly come into play. Whenever the Federal Reserve raises interest rates, the effects are often keenly felt in emerging markets. Higher U.S. yields reduce the relative attractiveness of emerging markets assets, prompting capital outflows and depreciating emerging markets currencies. For emerging market economies reliant on external financing for government budgets or current account deficits, these outflows are most problematic. Higher U.S. interest rates and the stronger U.S. dollar that typically accompanies it do not usually bode well for emerging markets local currency debt, with underperformance primarily on the currency side. Furthermore, emerging market central banks might be compelled to hike domestic interest rates to limit capital outflow pressures, raising bond yields in the process.
A stronger dollar also has implications for hard currency emerging markets assets. Local corporates and banks that have borrowed in U.S. dollars yet whose revenue streams or assets are primarily local currency denominated may find it harder to pay off their hard currency debt as emerging market currencies weaken. This can have negative implications for their credit metrics and ultimately their credit spreads. For local currency debt issuers, this problem does not arise — it's the investor in the debt that ultimately bears the currency risks.
While the size of the emerging markets debt asset class has tended to lag emerging markets' economic importance, it is clear that this is in the process of changing. The breadth and depth of the asset class may have historically been overlooked despite its growth in prominence but, as it continues to become more prevalent, we believe emerging markets debt will assume even more importance in the asset allocations of institutional investors.
Colm McDonagh is head of emerging market fixed income at Insight Investment, London. 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.
