Outlook 2017: Emerging market debt (absolute return)

  • A flexible, selective investment approach with a focus on downside protection will be required more than ever in 2017.
  • After making adjustments, a number of emerging markets are now better-equipped to face the impending challenges.
  • There are compelling investment opportunities in selected emerging market (EM) local government bonds. However, we believe US dollar-denominated EM bonds should be avoided.

The bad news

We believe that the conditions are in place for the US Federal Reserve to accelerate its process of monetary policy normalisation, thus exacerbating the recent pressures on bond markets both in emerging markets (EM) and globally.

Meanwhile, China’s deteriorating growth trajectory and skyrocketing debt ratios are likely to remain a major source of concern. Within this context, there is still a high risk that episodes of uncontained capital outflows from China could trigger intermittent dislocations in global financial markets.

The good news

The good news is that a number of EM countries have become better equipped to face these challenges thanks to the macroeconomic adjustments implemented over the course of the last three years.

These adjustments are now well-advanced in countries such as Brazil, Colombia, Russia, India, Indonesia and South Africa. These countries have already experienced large currency devaluations, a completed tightening cycle and a renewed focus on reforms. As a result, the inflationary pressures and the large current account deficits that these countries suffered from during the period 2013 to 2015 are now under control.

The charts below show the example of Indonesia, where the trade deficit has been eliminated and inflation dropped to multi-year lows.

Brazil is another example of post-crisis improvement, as illustrated by the chart below. This shows that Brazil now appears to be out of the danger zone judging by the recent amelioration in the “country risk score”. This scoring of various vulnerability indicators is based on the quantitative analysis framework developed by the Schroders Emerging Market Debt Absolute Return Team.

Stability in the face of 2016’s challenges

Markets have already started to reward this restored macroeconomic stability. At the beginning of 2016, a number of EM local government bonds and currency markets initiated a strong recovery from their oversold levels of recent years. It is particularly important to note that these markets have also recently shown some resilience in the face of various disruptive events.

Broad US dollar strength, the surge in capital flight from China, the Brexit vote, the military coup attempt in Turkey and the US presidential election are among the main challenging events of 2016 which failed to push the EM countries highlighted above back into crisis. This illustrates the fact that these EMs have now substantially reduced their reliance on short-term foreign capital.

Regained ability to ease

An important implication of this restored macroeconomic stability is the regained ability of a number of EM central banks to withdraw the emergency monetary tightening implemented in recent years. This is particularly the case for Brazil, where policy rates have just started to be reduced from an incredibly high level of 14.25%. Long-dated Brazilian local government bonds with yields at 12% could continue performing handsomely in 2017. The same could be said about investments in Colombia, Russia, Indonesia and South Africa where yields are still very high and where currencies have stabilised. Moreover, if the recent recovery in commodity prices continues, this positive outlook could be reinforced further.

2017: a year of performance differentiation

However, not all countries and all sectors of EM debt are well positioned to benefit from these trends. While attractive opportunities have emerged in selected local bond markets, hard currency (i.e. US dollar-denominated) debt should be avoided. This sector offers very low yields, poor liquidity and could suffer from its high sensitivity to US Treasury bond yields as well as from excessively high positioning by EM and global fixed income funds. Caution is also warranted towards a number of countries such as Turkey, where early warning signs of crisis are still flashing red.

Overall, an investment approach combining flexibility, selectivity and downside protection is, more than ever, required to get the best from the asset class during what should be a year of performance differentiation.