Emerging market debt: investors grow more selective

Emerging market debt has been through some notable highs and dramatic lows, but investors have not always discriminated between individual markets. Liam Spillane, Head of Emerging Markets Debt at Aviva Investors, believes that may be about to change.

Emerging market debt has been through some notable highs and dramatic lows over the past 18 months, mirroring variable sentiment towards emerging markets in general. In these sentiment-driven markets, investors have not notably differentiated between individual markets – the beta decision has been the most important. However, Liam Spillane, Head of Emerging Markets Debt at Aviva Investors, believes a shift may be changing.

At the start of 2018, most investors saw a supportive environment for continued global growth. The economies of China, the US and Europe all looked healthy and this seemed set to continue. Then China started to slow, while European growth moderated and only the US continued to perform well. US exceptionalism became the dominant driver of markets, prompting a rally in the Dollar, which, in turn, was the catalyst for further volatility in emerging markets.

“Market conditions are going to evolve and there will be more return dispersion, which should create a fertile environment for managers with a strong focus on risk-adjusted outcomes.”

Spillane says: “As is often the case, as the tide went out, it became clear who was swimming naked - Turkey and Argentina, notably. We found ourselves in a different environment. Uncertainly and volatility were felt across the entire emerging market debt space.” In particular, there was considerable volatility in local currency debt. The Aviva Investors team hunkered down – reducing the beta of the portfolio and idiosyncratic positions in Argentina and Turkey.

In this ‘risk-off’ environment, markets did not discriminate between Argentina, which was doing all the right things – engaging with the IMF, intervening in their currency, managing short-term liquidity – and Turkey, where policymakers were doing little to convince domestic and international investors that the economy was on a sound footing. Spillane says: “Turkey and Argentina were grouped together as bad poster children of emerging markets. A reliance on bottom-up fundamental analysis - a key part of our process - suggested a more favourable outlook for Argentina. However, the market was unwilling to give higher beta assets the benefit of the doubt or differentiate between them.”

The market began to change toward the third quarter of 2018. For Spillane, there was no specific catalyst, but there had been such a significant drawdown in emerging market debt assets that valuations had been early to reflect the reality of global growth backdrop when compared to other asset classes. The rally, when it came, was quick with a rapid improvement in prices. But while this was good for emerging market debt investors, the market was still not discriminating between individual opportunities. Market beta remained the key consideration for investors.

However, Spillane believes the environment is continuing to evolve: “We are coming to the end of the economic cycle at some point, though the exact moment is difficult to pinpoint. Market conditions are going to evolve and there will be more return dispersion, which should create a fertile environment for managers with a strong focus on risk-adjusted outcomes such as ourselves.”

He believes the global economy is shifting. “We have been in an environment where growth has been weak, but recession has been avoided. However, monetary conditions are getting easier as major central banks provide additional stimulus and the trade war has shown some tentative signs of being resolved. From here, our latest House View suggests those underlying growth concerns will remain elevated and that trade related uncertainties will persist, but that a global recessionary environment will continue to be avoided.

He adds: “The Federal Reserve has changed it path and China is able to provide more stimulus to the global economy if required. If we are correct about our macro outlook and the positive tailwind provided by the policy support, local currency emerging market debt c as an asset class could deliver as much as seven or eight percent in dollar terms, while hard currency could deliver something similar but looks particularly attractive in risk-adjusted terms. To our mind, it remains a positive environment for fixed income and particularly for emerging market debt.”

There remain strong valuation arguments for the sector, he says. Spreads are mid-range and therefore reasonably attractive, but valuations in local currency are more attractive because of the greater potential for appreciation in emerging market currencies. Valuations are one of the four key pillars of the team’s process. The others are macroeconomics, fundamentals and technicals. He says the technicals factor – which in part looks at asset flows into the sector – is also supportive: “The long-term average of inflows into the asset class is approximately $35bn per year and yet we’ve already seen $45bn come into emerging market debt this year alone. Most of that has gone into the hard currency debt, which is more defensive. This reflects lingering client uncertainty to a degree, which we expect to continue given the macro outlook.”

What does this look like in portfolios? The group is finding a compelling risk-reward balance in areas such as Kenya, Ghana and Nigeria, where investors are well-compensated for the underlying fundamentals. The portfolios are also overweight in Indonesia, Peru, Russia, Mexico and South Africa. 

Spillane adds: “Notable countries that we haven’t invested in so far this year include Turkey and Argentina. It is easy to make a case for Argentina – with some assets yielding up to 40-50% - but it is not on our preferred list simply because the fundamentals aren’t improving.”

Overall, his view is that emerging market debt remains in a bullish environment having already delivered returns this year of nearly 10 per cent and 12 per cent for local currency and hard currency debt, respectively. Nevertheless, he also needs to look at the potential for alternative scenarios. The biggest risk, as he sees it, is that the US trips into recession, which could push the wider global economy into recession. 

He says: “This would be the most concerning scenario, but the probability is quite low and diminishing. The Fed is changing direction. There is also a scenario where the US continues to perform well but China and Europe don’t improve. That scenario wouldn’t necessarily tip the global economy into recession but returns in the asset class are likely to be more muted than our expected base case.”

The group’s multi-factor investment approach is top-down and bottom-up. It is designed to help generate returns through different market environments and in different regions across the globe. For Spillane, this is the optimal way to build a diversified portfolio and ensure the portfolio does not become too heavily concentrated in the higher yielding markets within the asset class. Aviva Investors currently has three funds based on this process –Emerging Markets Hard Currency Bond, Emerging Markets Local Currency Bond, Emerging Markets Corporate Bond – alongside our strong capabilities in building segregated solutions for our investors, all of which are designed to tap into the growth in emerging markets with a diversified portfolio built to access alpha opportunities and deliver consistently strong risk-adjusted returns.”

Taken from Hub News Issue 42 Summer 2019.