Current trends likely to continue in the short term, Neuberger Berman’s Drijkoningen says

Rob Drijkoningen, co-head of Neuberger Berman’s Emerging Market Debt team, comments on the recent volatility in the markets.

Emerging markets debt (EMD) has suffered from negative returns thus far in 2013, reflecting a rise in US Treasury yields and increase in EM spreads. Over the past few years, the low-rate environment has led to significant inflows into EM fixed income generally, and it is now seeing outflows amid the US recovery and rising US rates.

Overall, emerging market economies are better equipped than in years past to deal with slowing of capital inflows or capital flight. Aggregate EM current account balances are stronger, as are EM international reserves, which will help central banks manage the situation. That said, we believe current trends are likely to continue in the short term,
perhaps beyond what fundamentals might justify.

Longer-term, however, we believe the appeal of EMD remains intact.

• Financial health: While economic growth prospects have recently been scaled back at the margin, the levels of growth and the overall healthy fiscal conditions and should contribute to further declines in debt-to-GDP, on average. We believe that public debt should decline as a percentage of GDP from 34.7% in 2012 (and 49.6% in 2003) to 32.7%, as EM fiscal balances are likely to average a modest -2.4% of GDP in 2013.

• Valuation: EMD’s underperformance, with spreads widening, has increased its appeal relative to other fixed income assets. While we are currently cautious and expect the recent selloff to continue, we do see valuation appearing in our market and have a positive longer term outlook.

• Investment Flows: Despite short-term trends, we believe that fixed income investors will continue to reallocate to EMD, which is currently underrepresented in their portfolios, providing a support for prices.

Value Opportunity: Local Currency Debt

Looking specifically at local currency debt, market rates have underperformed due to (a) their high level of positioning (prior to May) relative to EM USD sovereigns and (b) market speculation that, with weaker FX, EM central banks would have to raise target rates to keep inflation under control and prevent capital flight. We believe that the fear of aggressive rate hikes by central banks is exaggerated in most EM countries, given that they have adequate reserves to fight FX depreciation with direct intervention in the spot market, and that economies are generally sluggish, which limits the risk of inflation.

With the recent pullback, we are now seeing yield opportunities in some EM countries, such as Mexico and Columbia, which are pricing in substantial rate hikes that also have strong external positions and relatively benign
inflation dynamics.

Bottom Line

Despite the attractive qualities of economic growth, fiscal position, low correlations to other assets, and relatively high yields, many fixed income investors are just beginning to look more closely at EMD. Although current volatility
justifies short-term caution, it may also provide opportunities and attractive entry points to this increasingly significant asset class.

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