EM for the long run

There’s no doubt that emerging market assets have struggled in the past few years.

premium growth

Annual GDP growth rates for emerging and developed countries

A number of factors have been to blame: an appreciating dollar, amid US economic strength; weak commodity prices; and, more recently, expectations that the US Federal Reserve would tighten monetary policy amid an ever tighter domestic labour market.

But over longer time horizons, EM assets should benefit from stronger economic growth. And, on this measure, emerging economies have clearly outpaced developed markets over recent decades. Since 1990, the top 10 developed economies grew by an average of just under 2 per cent per year in inflation-adjusted terms. By contrast, emerging economies grew by more than 5 per cent a year.

Emerging market economies also appear to be growing more stable. Even when commodity prices slumped, commodity exporting countries like Mexico, Peru, Chile and Colombia sustained the shock reasonably comfortably. In part, that’s because EM countries have been making significant strides in diversifying their sources of growth, while fiscal restructuring and strengthening of domestic institutions, such as granting independence to their central banks, has further boosted these economies’ resilience.

EM fixed income benefits from economic growth, which is a key determinant of a country’s development and ultimately its political stability. Both, in turn, make it more likely that a sovereign borrower is willing and able to honour its obligations. And evidence suggests emerging market governance has broadly trended higher in recent decades, albeit with some erosion from their peak years around 2010, according to the World Bank’s indicators.

EM countries, however, have historically had a poor inflation record. That’s a particular danger for fixed income investors.

It helps that over the past couple of decades, inflation has trended down across EM economies, in part with general global deflationary pressures, but also as EM governments have learned painful economic lessons from episodes of overly lax monetary and fiscal policy. Another solution to this inflation risk has been for EM countries to issue debt denominated in hard currencies. Investors in such securities are rewarded with a substantial premium over US Treasury bonds, the benchmark risk-free asset, for the EM bonds’ relative lack of liquidity and repayment risk. For instance, the current yield on EM hard currency debt is 6.0 per cent, some 360 basis points more than what US Treasury bonds are offering.

Over time that yield premium adds up. For instance, since the start of 1998, the cumulative total return of the EM hard currency bond index (EMBI) is 393 per cent. Of that, 12 percentage points have been generated by a narrowing of spreads between the EM bonds and US Treasuries, with a further 14 percentage points coming from gains in US Treasury bonds. However, a whopping 367 percentage points of the total returns have been down to the compounding effect of the EM bonds’ coupons.¹

accumulating returns

Components of cumulative return for EM local debt

What’s more, EM hard currency bonds have a shorter duration of 7 years against 10 years for the US government paper. Shorter duration means that the capital value of the bonds is less sensitive to changes in interest rates, i.e. when rates rise the bond prices fall less.

Foreign exchange factors clearly affect EM debt priced in local currencies. But in exchange for devaluation risk, investors gain even more premium than on dollar-denominated EM debt. For instance, EM local debt currently offers a yield of 6.9 per cent, 450 basis points more than US Treasury bonds, and with the additional advantage of a relatively short 5 years’ duration.

Eventually, this premium swamps currency effects. For example, investors buying an EM local currency bond index at the start of 2003 would have suffered an 18 percentage point hit from currency effects by the fourth quarter of 2016, but would have earned 146 percentage points from the coupons. Once gains from the rise in the bond index’s capital value are factored in, an investor would have earned a 156 per cent return on these bonds.²

keeping it rolling

Rolling 5-year, 10-year and 15-year total US dollar returns for MSCI World and Emerging Markets indices

But over longer periods, this disadvantage fades. For instance, on a 10-year rolling basis, EM equities have a significantly higher average return than DM equities, with similar downside risks as in DM equities and with considerably better upside. This trend becomes even more evident on a 15-year rolling basis. In other words, the longer the investors’ time horizons, the better the performance they can expect to generate from EM equities relative to DM peers on both an absolute and risk-adjusted basis.

EM bonds and dividend-paying equities clearly have much to recommend them over the long run. But there are also reasons to believe that investors should begin raising their exposure over the next several months.

 Inflation concerns are mounting in developed economies, not least in the US, where unemployment has dropped to levels at which wage pressures start to appear, while US President-elect Donald Trump threatens to overheat the economy with a massive promised fiscal spending programme. But at the same time, inflation in emerging markets continues to trend down, even though we forecast real GDP to grow at more than double the pace of the developed world through to the end of the decade.

Meanwhile, political risks seem to be rising across the developed world. Brexit has cast a cloud over the UK while continental Europe is also facing potential ructions, not least from this year's French presidential election. That's not to mention the trade turmoil Trump's policies could yet ignite. Credit rating agency Standard and Poor's went so far as to argue that populist policies across advanced economies have eroded their differences with emerging markets.¹⁰

Better trade offs

Duration versus yield

EM bonds also have a much more attractive balance between yield and duration than most developed market counterparts. Add in their substantially higher yields and investors are more protected from the vagaries of central bank policy.

At the same time, recently stronger commodity markets should benefit EM currencies and EM economies more generally – although over the medium term an increasing shift towards domestically-focused companies should help buffer EM equity indices from the volatility of resource-dependent stocks.

What’s more, EM currencies are cheap relative to the US dollar. Indeed, the dollar is the most expensive it has been since the mid-1980s, making this an attractive entry point for EM assets, according to our economists’ analysis.

In other words, macro and market trends suggest that EM equities should gain from here while EM bonds should fare less badly than their developed market counterparts – which is to say, spreads should narrow.