We see emerging markets (EM) as one of the more attractive opportunities in global fixed income at the moment. First, the pickup in global growth is supportive of global trade, and thus emerging markets. EM growth is increasing, and for the first time in five years, the spread between EM and developed market (DM) growth is widening, which historically has been positive for flows and EM currencies.
A number of EM countries, like Argentina and Brazil, have also pursued important reforms over the last few years. Average debt/GDP in EM is 47%, significantly lower than in DM. And EM currencies have depreciated significantly since the onset of the taper tantrum, leading to a substantial improvement in current account balances. We are mindful of the rally thus far, but with yields averaging 5-6%, we believe valuations are attractive relative to other fixed income opportunities, especially considering close to 60% of global fixed income trades with yields below 2%.
IDENTIFYING THE BEST OPPORTUNITIES WITHIN EMD
In our EMD strategies, we take a total return approach to take advantage of the broadest possible opportunity set – hard currency sovereigns, corporates, and local currency debt. In addition, we look to capture inflection points, whether driven by structural reforms, political change or improving growth dynamics, in order to capture the greatest risk/reward and minimize downside risk. We find that most gains are priced in before these events actually occur, so we look to adjust positioning in anticipation of the event.
We also find that credits the market may deem among the riskiest can present attractive opportunities because they are often forced by economic and political realities to shift to a more orthodox policy mix.
EMD IN A RISING RATE ENVIRONMENT
We believe the developed market monetary policy backdrop will remain benign. Rising US rates are less of a concern, given the gradual and well-communicated path of Fed policy. We also believe the European Central Bank remains very deliberate with its exit strategy, and the Bank of Japan will continue with yield curve targeting. As such, we prefer higher yielding markets in countries that are undergoing structural reforms. These investments provide spread cushion in a rising rates environment.
THE ‘RIGHT’ ALLOCATION TO EMD IN A GLOBAL FIXED INCOME PORTFOLIO
EMD now represents 16% of global fixed income. In other words, EMD has grown from a ‘core plus’ allocation to a standalone asset class. We have performed various efficient frontier analyses which indicate the optimal global fixed income portfolio over the test period (2003 through the end of 2016) would include at least 50% in EMD. We recognize that number is large and unrealistic in practice, but believe most institutional investors are significantly underweight even a neutral allocation and seem generally inclined to add on any sell-off. In addition, we continue to see new investors making strategic dedicated allocations to the asset class and expect this to continue as investors capitalize on the improving growth dynamics and attractive valuations.