Multi-Asset Insights: Opportunities in emerging market debt?
The latest insight from our multi-asset team explores the prospects for emerging market debt with US interest rates expected to normalise.
Is there a risk of another taper tantrum?
In summer 2013, fears that the Federal Reserve (Fed) would imminently begin to taper its bond purchasing programme led to a broad sell-off in emerging markets.
Economies with large and growing twin (fiscal and current account) deficits were hardest hit due to the heightened risk of an abrupt internal adjustment if there was a reduction in liquidity.
That is, if economies are unable to borrow as much money from foreigners, consumption, investment or government spending (or all three) must adjust.
Once that adjustment becomes sufficiently large, it represents a risk to financial stability.
Although the delay to tapering has bought emerging market economies some breathing space, we expect an eventual return to this focus on fundamentals when liquidity again becomes an issue.
Figure 1 shows how emerging market economies are performing. Most emerging economies have managed to improve their position over the last year, although we have yet to see an export recovery in line with the recovery in developed markets.
However, notable exceptions are the commodity-dependent Latin American countries, where current account deterioration has led to an increased reliance on external financing flows.
Yield supression contributing to risk environment
The broad emerging market debt universe generated positive returns in the first four months of 2015 despite pessimism carried over from last year.
Downward revisions in global growth, uncertainty surrounding Fed normalisation, and country-specific issues contributed to the negative environment in the first quarter.
However, quantitative easing in Europe, a dovish statement from the Fed in late March and over 20 central banks easing monetary policy in the first quarter allowed for a recovery in risk assets.
In particular, the low to negative levels of developed market yields have helped to encourage risk taking.
Russia outperformed the broader market, helped by the stabilisation in oil prices and the diminishing threat of additional sanctions against the country.
The cautious sentiment towards emerging markets helps keep valuations attractive, especially compared to developed markets.
However, we believe divergent conditions across emerging markets will remain the key driver of emerging market performance in the future.
What will be the impact of a Fed rate rise?
When the Fed proceeds to cautiously lift the base rate, the impact is likely to differ substantially across emerging markets.
We believe the downward adjustment in growth and the dramatic realignment in emerging market currencies will not destabilise emerging markets.
On the other hand, significant opportunities within emerging markets, especially in the local currency debt market, could be unfolding over the next one or two years.
We have been seeing some major emerging countries remain resilient, particularly those with strong external liquidity and solvency support.
However, in the near term we remain selectively positive on local currency debt given headwinds from dollar strength and currency volatility and we expect dollar-denominated assets to remain better supported.
As a result we are upgrading dollar-denominated debt to neutral as spreads (yields relative to US Treasuries) remain fairly attractive.