Emerging markets are rebounding as part of a significant turnaround that is setting them apart from other asset classes in fixed income, making them an attractive risk reward proposition for investors.
The best way to understand this transformation is to view it through the framework of global liquidity. While all asset classes were adversely affected when the Federal Reserve flipped the switch and began its tapering talk last May, emerging markets were hit especially hard. During that time, the most fragile economies began the process of adjustment, struggling to recalibrate in an environment of declining global liquidity.
That group of countries — Turkey, Brazil, India, South Africa and Indonesia, collectively known as the Fragile Five — had to adjust as currencies weakened, interest rates rose and foreign exchange reserves fell. Growth, as it became clear, had to slow to shrink external deficits to a level where the market would fund them in an altered liquidity environment. That process, which began in the fourth quarter of last year, was led by Indonesia, whose currency began to stabilize and then rally, with the swift adjustment being recognized by the market.
As those developments continue to take place, the market will begin to realize that there's less tail risk in the asset class and asset prices will then adjust to that increasingly benign environment. As it becomes more obvious that the deficits are responding, tail risks for the asset class, as a whole, will decline and asset prices, in general, will rally — precisely what is beginning to transpire now.
LOCAL RATES ATTRACTIVE
As long as foreign exchange reserves stabilize or rise, and external deficits shrink, currencies in countries that aggressively adjusted interest rates should begin to respond positively. Local rates are very attractive, as most emerging-markets countries have raised interest rates aggressively. Under those conditions, one of the best investment opportunities is in the local rates of the former Fragile Five, where investors can buy bonds with 8% to 12.5% yields and minimal interest-rate risk. The areas within emerging markets with the most interest-rate risk are sovereign and high-grade corporate debt.
Now that the Fed is midway through tapering its bond purchase program, investors have started to focus on a potential change in the central bank's forward guidance. That means the Fed funds rate will be kept near zero for a prolonged period, raising questions about how bond markets will continue to be affected. However, it's important to note that tapering has already been priced into the markets.
For emerging markets, the “pricing in” of bond tapering began last May with the very sharp fall in emerging-markets currencies as well as sovereign and corporate dollar debt. For the rest of the year, emerging-markets bonds traded very poorly. Continuing to price in bond tapering over a long period of time in emerging markets puts the asset class ahead of most other fixed-income sectors.
U.S. high yields, for example, were hit but now are trading at below 5%. Emerging-markets yields are trading well above those levels.
The emerging-markets turnaround has not come without some misperceptions. One of those has been that emerging markets reached crisis levels. A crisis in this asset class only happens when countries and companies are not able to come to the market for financing. But the reality is that any default risk is not meaningful if the parties can still fund themselves. And although the parties may have been delayed a few weeks or a month, they were ultimately able to do so.
Investors should fully understand that most of the risk with emerging markets is interest-rate risk rather than emerging-markets risk, as most of the indexes are investment-grade securities that trade with high correlation to U.S. Treasuries. Investors should be thinking about emerging markets with a very sharp focus on duration. The way to manage duration is to access the entire opportunity set, not just the most liquid part of emerging markets — sovereign debt, which has the highest correlation to U.S. Treasuries.
Emerging-markets assets are clearly rebounding. Investors who understand how this asset class has managed a successful turnaround will be the ones best-positioned to spot the best opportunities.
James Barrineau is co-head of emerging-markets debt relative for Schroder Investment Management North America Inc., a unit of Schroders PLC.