The author of this commentary sets out the case for holding emerging market debt.

Francesc Balcells, chief investment officer for emerging market debt at FIM Partners, is understandably keen on this asset class. Even so, he lays out a set of reasons why other investors should be positive about EM debt – within certain boundaries. It adds to the kind of commentary that we receive at a time when wealth managers are trying to work out how to set asset allocation in light of the pandemic and its aftermath.

The usual editorial disclaimers apply to views of outside contributors. To respond and join the debate, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com
 
European investors continue to lament domestic fixed income yields of zero and even below. Yet the environment for emerging market debt (EMD) holds attractions for investors looking to diversify and receive income.

Where else can one build a fixed income portfolio with yields ranging from 3 per cent for an IG-only portfolio to 7 per cent for a high-yield one, without incurring any currency risk?  What other bond asset classes can generate high single-digit returns on the back of spread compression when there is barely any spread left? 

The pushback comes normally in two forms. The first is timing - periods of Fed policy normalisation have not been particularly benign for EM debt. The second is emerging market fundamentals, which are not as good as in the past and political risk is elevated. We think both arguments can be easily debunked.  

Not a repeat of “taper tantrum”
First, concerning policy normalisation risk, the US Federal Reserve is adjusting its approach because of higher growth and inflation. Reflation is unambiguously good for EM, which benefit from stronger global demand and higher commodity prices. The external environment has not been as good as it is today since the financial-crisis years following 2008 in which EM delivered very strong returns.

Notice how different this is from the “taper tantrum” episode of 2013, a period often compared with the current environment. Unlike today, back then the FED was tightening liquidity when global growth was still relatively tepid amid a weak expansion. 

Second, the FED approach to normalisation today is gradual and very well-telegraphed. In contrast, the FED in 2013 took investors by surprise. As a result, the market is well-positioned for an adjustment in core rates, particularly after the 125 basis points “shake-out” in Treasury yields from the summer of 2020 to March 2021. 

Today very few funds are “long” duration, a fact corroborated by futures positioning data from the Chicago Mercantile Exchange. Since March this year, after the 10-year US peaked at 1.74 per cent, US inflation has passed through 5 per cent, the FED moved up its timeline for rate hikes (as per the dots plot), and yet the 10-year US Treasury yield is now below 1.5 per cent.

Third, while EM hard currency debt is admittedly a long-duration asset class, this is a “risk factor” that can be dealt with by actively managing a portfolio. FIM runs an EM debt fund with an 8 per cent carry and a duration of 4.5 years. How so? By diversifying across EM and by concentrating in short-maturity exposures where we have good visibility on the credits. And by selling Treasury futures against EM long bonds. 

EM external balances are strong
On EM fundamentals, one must distinguish between the external and the fiscal accounts. The external accounts (e.g., trade balance, financial flows, and the external debt stock) of the major EM economies, look the strongest they have been in decades. 

In 2013 people used to talk about the “fragile five” economies in EM - India, Indonesia, South Africa, Brazil, and Turkey - which exhibited large external imbalances. This is no longer the case, except for Turkey. The combination of very favourable terms of trade and relatively depressed imports is giving a significant boost to trade balances across many countries. 

On the fiscal side, much like in developed economies, there has been a noticeable deterioration compounded by the COVID crisis. Debt to GDP ratios have risen materially and the fiscal space for more expansionary policies has narrowed significantly. 

The immediate fiscal pressures, however, will lessen as growth (and inflation) are now accelerating in EM, which will help improve debt dynamics and stabilise debt to GDP ratios. Longer term, however, a fiscal adjustment will be required to avoid a fiscal crisis erupting in a number of countries. 

The contrast between the fiscal and external accounts also speaks to asset class differentiation within EM. Hard-currency debt leans more heavily on balance of payments considerations. After all, the capacity to pay back the USD-bonds hinges upon a country’s ability to generate dollars as analytically captured by the balance of payments. Fiscal dynamics have more of a bearing on local rates and currencies. 

Political risk cuts both ways
Finally, there has seemingly been an intensification of political risk including binary elections in Ecuador and Peru, sanctions in Russia, political machinations in Turkey and geopolitical risk in the Middle East. Political risk has always been part and parcel of EM due to the institutional fragilities of the countries. Two growing trends, however, may explain its intensification. 

The first, is the politics of COVID. In much the same way that the 2008 financial crisis and the economic dislocations it created led to a change in the political landscape across the world (albeit with a time lag), we think something similar could be in play today. 

It is hard not to envisage a situation whereby the social and economic devastation fuelled by COVID does not lead to some form of political blow-back. It is a fact that economic shocks breed social discontent, and that social discontent is a fertile ground for political instability. 

Second, political polarisation is on the rise, a phenomenon, which, of course, is not exclusive to emerging markets. Traditional parties are floundering, and new actors are emerging across the ideological spectrum. Technology and the role of social media make it harder for incumbents to control the flow of information. The politics of COVID and polarisation go hand in hand, reinforcing each other in the process.

The two phenomena above are not a prediction of “bad” political outcomes but a view on political volatility. Indeed, EM has one big advantage over developed markets: extreme outcomes, such as populism and authoritarianism, have been tried and tested time and time again.

Therefore, political change could go in either direction, cementing or even strengthening incumbents or breaking them apart. The point is that the distribution of possible political outcomes has increased in our view, creating selling and buying opportunities along the way. 

EMD in asset allocation
All in, any allocation to fixed income will do better over time by allocating to EM debt. It is an asset class that is reflation-friendly and with carry/yield. 

Moreover, EMD is trading cheaply relative to competing asset classes, notably US high-yield and global credit. We believe that investors can use active management to address duration and default risk in EMD, while optimizing yields and diversifying risk in their fixed income portfolios.