Volatility is back but not all emerging markets are exposed, says BNY Mellon’s Larson
Urban Larson, product specialist, emerging markets debt at Standish, gives his view on the volatility affecting emerging markets bonds and currencies.
He explains why the troubles of a handful of countries are not indicative of a broader emerging markets crisis
Anticipation of lower global liquidity has helped highlight the most fragile emerging markets without hurting the sound fundamentals of most countries in the asset class.
Argentina has garnered headlines due to a sharp fall in the Argentine peso as the country’s heterodox policy model shows signs of age but it is very much sui generis and its bonds are among the most speculative in the emerging markets. Perennially troubled Ukraine is also very much a speculative investment and the current political turmoil further stresses the country’s already weak fundamentals without setting much of a precedent for other emerging markets.
Investment grade rated Turkey is more widely held by investors. Market concerns over the country’s current account deficit have been compounded by unclear monetary policy and an outbreak of political tension due to a major corruption scandal. This has led to significant currency weakness that the Turkish Central Bank has struggled to contain. We have been underweight all three of these markets in all of our strategies for some time.
Despite the troubles of a handful of countries, most emerging markets remain considerably less indebted than developed markets and retain the ability to make adjustments in both fiscal and monetary policy in response to market pressures, as many have already begun to do. With the development of deep and broad local currency debt markets, emerging markets public sector finances are significantly less vulnerable to currency depreciation than in the past, when emerging markets borrowing was largely in US dollars.
For this reason, we do not expect currency volatility to trigger a balance of payments crisis in the emerging markets, as it might have in the past. In these circumstances the exchange rate is free to absorb the market volatility that in the past has been known to bring down entire economies.
Valuations are attractive but differentiation is key
The recent sell-off has brought valuations to a level that already reflects an increased level of risk. Spreads on US dollar-denominated emerging markets debt are now
higher than spreads on US corporate bonds, although historically they have been lower. Similarly the spread on US dollar corporate emerging markets debt is now
higher than that on US high yield, although the former is rated investment grade. In local currency debt, the benchmark’s over 7% yield is above its long term average and
is particularly attractive given the strong quality of the asset class (rated BBB+). Additionally most emerging markets currencies are close to or below their long-term
We expect market participants to continue differentiating between countries, credits and currencies even after the current volatility subsides. We are more positive on those countries that have sound fundamentals and are better placed to directly benefit from stronger growth in the US and other developed markets. We remain cautious on the outlook for those countries that have less flexibility in fiscal and monetary policy. We have a small underweight in duration across all of our portfolios. In US dollar debt
we see particular value in quasi-sovereign and corporate issues from countries with positive fundamentals.
In local currency bonds we are overweight Latin American rates at the expense of duration exposure in Asia and Central Eastern Europe Middle East & Africa (CEEMEA) and are overweight select currencies which are the best placed to benefit from global recovery.