e-fundresearch.com: The dynamics of global growth and political risks are shifting. How does this impact EM investors?
Colm McDonagh: Turkey has been a recent reminder of the political risk that can stem from EM, but political risk is becoming a more global phenomenon. The UK’s vote to leave the European Union, the rise of populist parties across Europe and the political noise surrounding the US presidential election are all reminders of this.
But this is just one element of risk. Risk is being redefined in this new era of negative interest rate policy. Rates in developed markets continue to plumb new lows. 10-year German bunds, the bedrock of European markets and the benchmark against which other securities are priced, are now in negative territory. Meanwhile, the yield on 20-year Japanese government bonds recently fell below zero for the first time. Investors, concerned by global risks, are accepting losses on their capital but are, in our view, overlooking the risks embedded in developed markets at current levels, underscoring the pervasiveness of the current negative yield environment.
This is leading some to re-examine what the true “risk-free” rate is. Emerging countries behave like a derivative of global developed market monetary policy systems. As regional monetary policy systems shift, smaller monetary and currency regimes in emerging economies are likely to arise, increasing the heterogeneity of the asset class and in turn the opportunities (and risks) that arise will also likely be more varied.
Meanwhile, developed markets are becoming increasingly saddled with debt and lacking the means with which to service it given that economic growth remains anaemic. Following the financial crisis, many EM countries have emerged with relatively less challenged public finances while also having significantly built huge foreign currency reserves, giving some financial flexibility.
e-fundresearch.com: In your view, does the resurgence of flows into EM signal a time for caution or optimism?
Colm McDonagh: EM bond funds saw record inflows in July following the UK referendum, according to data from EPFR Global. Some investors will be wondering whether it is time to increase EM exposure or take a countercyclical view. EM flows are highly cyclical and have a tendency to overshoot either to the upside or downside given flows are often highly sentiment driven. We acknowledge supportive flows, and the relative yield capture, but are taking some risk off at the margin.
While we maintain our positive view on EM assets over the medium and long term, a move lower in commodity prices and resumption in the US dollar’s upward momentum could be among the factors to cloud the near-term outlook.
We expect emerging countries to reach an economic inflection point this year as fundamentals continue to improve. There have been clear signs of stabilisation in EM growth indicators such as global trade, balance of payments positions and purchasing managers’ indices, which point to a renewed divergence in economic growth between the developed and emerging world, in contrast to 2015.
e-fundresearch.com: You have often referred to EM debt as an underappreciated and misunderstood asset class. Is this still the case?
Colm McDonagh: Investors continue to be structurally underweight EM fixed income in their portfolios despite its growing importance. EM represents almost 50% of global GDP and is expected to keep growing, supported by favourable economic tailwinds and demographic trends. Given valuations are attractive relative to developed markets and on an historical basis, we would argue investors’ under-allocation to the asset class springs from a perception, or rather misperception, that EM is a homogenous high risk/high reward opportunity set. Global bond investors will increasingly have to explore investment opportunities outside of their natural comfort zone.
e-fundresearch.com: How would you define EM debt?
Colm McDonagh: The definition of EM debt is becoming more blurred as time goes on. The universe is vast and a truly global opportunity set, worth over $14 trillion and covering over 70 countries across a range of sectors and issuers, from investment grade through to high yield. Put differently, this gives investors the optionality to scale into different risk and return drivers.
e-fundresearch.com: How should investors approach the asset class?
Colm McDonagh: The mechanism of extracting value from EM is changing and shifting away from what has traditionally not worked well. How investors access EM debt can have a significant impact on their risk/return profile. Traditional market-capitalisation-weighted beta strategies have long been the most popular way to gain access to EM but mainstream EM debt indices incorporate material weaknesses, namely liquidity problems, step changes in volatility and uncertainty over capital preservation. They also tend to lack risk calibration. These factors often combine to undermine investors’ objectives.
As such, interest in alternative strategies that address and accommodate the scale, volatility and complexity of EM has risen. Our approach is to focus on absolute return rather than index-relative return. This means we can invest opportunistically, seeking investment ideas that we think present the most attractive risk/reward profiles across the EM debt universe, in hard and local currencies, while also maintaining a strong focus on capital preservation.
e-fundresearch.com: What is your outlook for EM corporate debt?
Colm McDonagh: Typically, EM corporate debt is seen as a riskier version of external debt or local currency debt, but that is a common misperception. Two thirds of EM corporate debt is now investment grade.
The credit quality of EM companies has been transformed over the past decade. EM corporates exhibit significantly lower financial leverage and are more cash rich than similarly rated developed market peers, yet they offer a greater credit spread premium. In our view, investing in EM corporates is about capturing the structural premium they offer over their global counterparts as emerging countries gain an increasing share of global GDP. In the medium term, the technical picture is very supportive as many issuers have bought back their debt in recent market weakness.
So, contrary to consensus, we think the asset class is not as vulnerable as many people think. Naturally country selection (or avoidance) and fundamental understanding of the issuers in which you invest is key to outperformance, something that is often not fully understood by investors through a market cycle.
