Investors are facing more uncertainty in 2023. However, there are bright spots – inflation is beginning to moderate, central banks are slowing the pace of tightening, and fixed income valuations are now attractive across many sectors. Against this backdrop, emerging market debt (EMD) warrants a closer look by Australian investors as it offers attractive yields relative to other fixed income asset classes with lower volatility than equity assets.
While emerging market investing is familiar to Australian investors, it is often under-represented across portfolios. Much like emerging market equities, EMD allows investors access to economies that are growing faster and producing more than developed market economies. EMD has matured as an asset class over the past 30 years. In the early 1990s, there were few countries in the index, and crises from the mid-1990s to the early 2000s resulted in the asset class being perceived as a high-risk proposition. But today, many EMD issuers have robust debt profiles and better credit quality than in the past. Furthermore, the depth and breadth of liquidity has increased as the size of the overall market has grown to approximately US$5.5 trillion, or almost AU$8.4 trillion, and EMD now comprises nearly 15 per cent of the global bond universe.
For those investing within a super fund framework, the recent “Your Future, Your Super” (YFYS) regulations have added more complexity to building portfolios. EMD can pose a challenge within this new regime, being an “off-benchmark” allocation, notwithstanding the EMD allocation within the YFYS International Fixed Interest benchmark, the Bloomberg Barclays Global Aggregate Index (hedged to AUD), however, it can also benefit portfolios in potentially generating meaningful excess returns with potentially lower volatility.
EMD can be issued in hard currency and local currency. Hard currency EMD refers to debt issued primarily in US dollars but also in euros and yen. Local currency EMD refers to debt issued in the issuer’s domestic currency. For Australian investors, hard currency EMD can be hedged back into Australian dollars or left unhedged, noting that the AUD has historically provided a natural hedge.
For Australian investors, local currency EMD has exhibited lower volatility at 8.3 per cent, compared to the 11.4 per cent experienced by a US investor. While the volatility of hard currency EMD, at 9.1 per cent, has been similar to the experience of the US investor.
Over the past 20 years, EM local debt has been through several cycles. The typical cycle is characterised by four stages: 1) a period of Fed hawkishness; 2) a weakening of EM local bonds and currencies; 3) EM central banks start hiking interest rates to stabilise inflation; and 4) EM currencies stabilise, inflation decelerates, and the real yield on local currency debt rises.
We have witnessed three EM local debt cycles: one before and two since the Global Financial Crisis. The first one was the 2004 to 2006 midcycle Fed tightening, then came the 2013 taper tantrum, and then 2018 Fed hawkishness episode.
In the current EM local debt cycle we are about to enter the fourth stage, which is typically associated with robust performance. The EM policy cycle is for the most part complete at this juncture, with a number of EM central banks already having hit the policy pause button and local markets anticipating future rate cuts. In addition, the US dollar may be running out of steam in the coming period and EM inflation is showing signs of normalisation, which is supportive of local fixed income.
We believe EM local debt yields are attractive on a relative value basis against developed markets (DM), with EM still offering a pickup of 2.80 per cent over DM rates despite the major rate correction in the DM world. The valuation of EM currencies is also attractive. In particular, a basket of EM currencies currently trades near multi-year lows against a basket of USD/EUR on a real basis. Finally, EM currency valuations have historically been positively correlated with commodity prices, although EM currencies have lagged last years’ commodity rally. This may point to a positive signal in terms of EM currency tactical valuation.
While investors need to understand the EM local debt cycle from a global macro, top-down perspective, a strong country selection process – along with sovereign credit analysis with a focus on local markets that are supported by strong fundamentals –is also essential. Additionally, an understanding of local monetary policy dynamics and local market technical factors, which can impact duration risk, is required.
A key risk to emerging market debt is a global hard landing. In a global recession, the US dollar usually appreciates due to a flight to safety. If that occurs, it could weaken EM currencies and would likely delay the ability of EM central banks to cut rates. While global growth will probably slow this year, recent developments, such as the end of China’s zero-COVID policy and reduced energy risks in Europe, have reduced the chance of a hard landing.
We believe that there is a compelling case for Australian investors to consider a strategic allocation to EMD. It is a mature asset class that allows investors access to economies that are growing faster and producing more than developed market economies, and many EMD issuers have robust debt profiles and are of a higher credit quality than in the past.
Ward Brown, fixed income portfolio manager, and Joshua Barton, relationship manager and head of institutional sales, MFS Investment Management