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The case for Emerging Market Debt

Recent troubles in Turkey and Argentina may make investors nervous about emerging markets. However, taking a long-term view, we believe emerging market local currency debt (EMD) is currently an unusually attractive asset class on a risk-adjusted basis. We forecast 10-year returns of 5.9% for sterling investors, with a volatility two-thirds that of equities. Compared to the very low return forecasts for developed market bonds and the subpar outlook for equities, this looks like a potentially compelling return.

The point of strategic asset allocation is to take the long view: rotating away from the expensive assets that everyone loves to those offering value.

The relative attractiveness of local currency EMD deserves some explanation. In the past, this asset class has never gained a substantial place in most investor portfolios. Why does it deserve a substantial allocation today? Its current competitiveness is a confluence of several factors.

Higher yields

EMD local bonds offer much higher yields than are available in developed markets, particularly for investors in the UK and elsewhere in Europe where yields on government bonds remain at rock bottom.

At around 6.8%, the yield on the standard EMD local currency index (JP Morgan GBI EM Global Diversified) is much higher than in developed economies. The wide yield spread has resulted from the collapse in developed market yields, rather than a rise in EM yields. Developed market (DM) yields have collapsed because of the global glut in savings relative to demand for capital for public and private investment, together with the fading impact of the quantitative easing. EM yields have not, in general, suffered from these headwinds. Higher expected policy interest rates and inflation have kept EM bond yields closer to pre-crisis averages.

Figure 1 Yields for EMD index vs developed market bond index

Source: Bloomberg, JP Morgan, September 2018.

Past performance is not a guide to future results.

As a result, the gap between EM sovereign yields and developed-economy yields is close to the highest it has been in the last decade. Compounding a 7% yield over a 10-year period generates a return of 97%, compared with just 15% from UK gilts yielding 1.4%.

Economic governance

2018 has been an uncomfortable year for emerging markets. A trade war, higher US rates, a strong dollar and twin crises in Turkey and Argentina have shaken investor confidence.

Like Asian economies in the 1990s, Turkey’s government and its corporate sector have made the mistake of accumulating large dollar-denominated debts, while relying on income in Turkish lira to repay it. The precipitous fall in the lira (70% year to date) now makes dollar debts hard to repay. Lenders are reluctant to provide new loans.

Prior to the 1998 Asian crisis, this kind of ‘sudden stop’ problem was widespread. But today most EM economies are in much better shape. Debt levels are relatively low as a proportion of GDP, and have longer maturities. Emerging-market central banks hold a much larger stock of dollars in their reserves. A much greater proportion of debt is issued in local currencies, so the risk of currency mismatch is smaller. Fiscal and monetary policy institutions have also improved, and debt markets have matured and deepened. Finally, in the Asian crisis, many countries had large current-account deficits, draining foreign currency reserves. This time most countries have much smaller imbalances.

There is no denying that the environment is now more challenging for EM economies.

And we do expect somewhat weaker growth. But the risks of a widespread crisis are quite low. And a lot of the potential bad news is now priced into EM assets. The EMD index is down around 7.5% this year in sterling terms, with most of this loss coming from currency depreciation.

Currency risk

While yields are the dominant source of return for EMD in the long term, currency can have a big impact over the short term - as, indeed, it has had this year. However, from a long-term returns point of view, the key issue is how far currencies are from their fair value levels. If EM currencies are expensive, their subsequent depreciation will be a drag on long-term returns. If they are cheap, the reverse is true.

This is where we are now. EM currencies have depreciated heavily in recent years, falling over 40% against the US dollar since their post-crisis peak in 2011 (and by 20% versus post-Brexit vote sterling).

Figure 2 JP Morgan EM FX index (vs USD)

Source: Bloomberg, JP Morgan, September 2018.

Past performance is not a guide to future results.

Equilibrium exchange rate models suggest that EM currencies are now on average below their fair value. As a result, we now forecast appreciation in real terms. Inflation differentials between EM and DM continue to be a modest drag on expected nominal returns, offsetting some of the real appreciation, but overall we expect a neutral to positive contribution from currency returns in the next few years.

This does not mean that EM currencies will not be volatile. Risks from rising US interest rates and slower growth in China may well lead to further market concerns about EM currencies. But this volatility should be within the expected range and should not trouble long-term investors.

A confluence of factors

Today EM local currency bonds offer a combination of high yields and cheap currencies. This coincides with a period when other asset classes offer relatively low expected returns. Low bond yields, fairly tight credit spreads, and expensive equities mean that the competition from other asset classes is unusually weak.

We have certainly seen some choppy waters for EM debt this year. But as is so often the case for strategic asset allocation, assets classes often offer the best value when the clouds appear dark and investors are nervous.