EMERGING MARKET DEBT TAKES CENTRE STAGE · • Among the key factors affecting EM debt performance...
Transcript of EMERGING MARKET DEBT TAKES CENTRE STAGE · • Among the key factors affecting EM debt performance...
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EMERGING MARKET DEBT TAKES CENTRE STAGE NOW A CORE PART OF THE GLOBAL FIXED INCOME LANDSCAPE
OCTOBER 2019
> Emerging market (EM) economies are taking a more prominent role globally while EM debt constitutes a significant and growing part of the global bond universe. In this paper we examine the factors that drive this asset class.
EXECUTIVE SUMMARY
ECONOMIC EVOLUTION: EM ECONOMIES ARE TAKING A MORE PROMINENT ROLE GLOBALLY
• In nominal US dollar terms, emerging market (EM) economies’ share of global GDP has risen from 20% to 43% or from 40% to 60% in purchasing power parity terms
• Since China’s accession to the World Trade Organization in 2001, EM’s share of global trade has grown from just over 30% to almost 45%
• Twenty years ago most of the world’s bilateral trade was between the most developed countries. Today almost half of bilateral trade now involves at least one EM country
• Although EM government debt is now approaching 50% of GDP, it remains markedly below the 108% level of advanced economies
MARKET STRUCTURE: EM DEBT MAKES UP A SIGNIFICANT AND GROWING PART OF THE GLOBAL BOND UNIVERSE
• Back in 2000, EM debt represented just 2% of the global bond universe whereas today it is closer to 25%. A trend toward greater bank disintermediation should see this continue
• Since the global financial crisis, EM corporate debt has become very much a standalone asset class. It has quadrupled in size, and at US2.3trn, now stands at twice the size of both the EM hard currency sovereign debt and US high yield markets
MARKET BEHAVIOUR: INCOME HAS TENDED TO BE A LARGE DRIVER OF EM DEBT RETURNS OVER THE LONG TERM
• EM debt returns have traditionally been most attractive in hard currency. While EM local currency debt can, at times, generate some of the strongest outright returns, it can also be the most volatile sub-asset class leading to a low Sharpe ratio
• Income has tended to be a large driver of long-term EM debt returns, while spread and interest rate duration volatility dominate returns over shorter periods
• Among the key factors affecting EM debt performance are expectations of the emerging market versus developed market growth differential, US interest rates and the US dollar as well as developments in the domestic EM investor base
1,2 Source: IMF, Insight, August 2019.
CHINA’S ACCESSION TO THE WORLD TRADE ORGANIZATION (WTO) IN 2001 ACCELERATED A SHIFT IN THE
GLOBAL ECONOMY’S CENTRE OF GRAVITY. EMERGING MARKETS ARE NOW MAJOR CONTRIBUTORS TO GLOBAL
ECONOMIC OUTPUT AND TRADE.
THE GLOBAL ECONOMY’S CENTRE OF GRAVITY HAS SHIFTED TO EMERGING MARKETS
The composition of global GDP has changed markedly since
China’s accession to the World Trade Organization in 2001.
In nominal US dollar terms, EM economies’ share of global GDP
has risen from 20% to 43% (Figure 1), or from 40% to 60% on a
purchasing power parity (PPP) basis (Figure 2).
Double-digit growth for much of the last two decades has
propelled China’s economy to second largest in the world in
nominal US dollar terms (US$14trn). However, this is not just a
China-centric story. At US$22trn, the economic heft of EM
excluding China exceeds that of the US and UK combined. India
and Brazil both feature alongside China on the list of the world’s
ten largest economies, with a further six EM economies listed
within the top twenty.
ECONOMIC EVOLUTION
Figure 1: EM share of Global GDP (nominal US dollar)1
0
20
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60
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100 Advanced economiesEmerging Markets
202320182013200820031998
%
n Emerging markets (LHS) n Developed markets (LHS)
0
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World GDP
World GDP (RHS)
Trillion (USD
Figure 2: EM share of Global GDP (PPP basis)2
0
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Emerging Markets
202320182013200820031998
%
n Emerging markets n Developed markets
FROM EXPORT-DRIVEN TO CONSUMER-DRIVEN GROWTH
Traditionally EM growth has been seen as export-driven, supplying
manufactured goods to meet the demands of consumers in the
US and other developed markets (DM). It was the so-called East
Asian Tiger economies of South Korea, Taiwan, Hong Kong and
Singapore that led the way with this approach to growth from the
mid-1970s onwards. This was followed by a number of export-
oriented newly industrialising South East Asian and Latin American
economies, and most latterly China upon its WTO accession.
Gross capital formation and consumption have since become the
most relevant EM growth drivers however (Figure 3 and 4). We see
consumption’s role as an EM growth driver becoming even more
important over time as these countries continue to urbanise and
their middle classes continue to expand, similar to the trends that
have already been observed in DM.
Figure 3: Real GDP contributors (Top 20 EM ex.China)3
0
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2016
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n Government expenditure n Consumptionn Gross capital formation n Net exports Real GDP yoy% change
Figure 4: Real GDP Growth Contributors (China)4
02468
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Net Exports
Gross Capital Formation
Consumption
2018
2017
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2015
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n Consumption n Gross capital formation
n Net exports Real GDP yoy% change
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-1
Net Exports
Lorem ipsum
3,4,5 Source: IMF, Insight, August 2019.
THE RISE OF INTERREGIONAL TRADE
Developments in global trade follow patterns similar to those for
GDP. China’s entry into the global multilateral trading system via
WTO accession was a significant moment. Since that point, EM’s
share of global trade has grown from just over 30% to almost 45%
(Figure 5). And while there are various unknowns clouding the
global trade outlook – US unilateralism/protectionism and the
future of Trans-Pacific trade – we anticipate that the next major
shifts in global trading patterns will come from within EM ex-China.
Twenty years ago most of the world’s bilateral trade was between
developed countries. Today almost half of bilateral trade now
involves at least one EM country. In recent years we have seen a
number of bilateral trade deals strengthening ties between EM
economies. China-Latin America trade, for example, has increased
from US$17bn in 2002 to over US$300bn today, and China has
become the top trading partner of Brazil, Chile, Peru and Uruguay.
Figure 5: Decomposition of global trade5
0
10
20
30
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50Developed Markets
Emerging Markets
2017201620152014201320122011201020092008200720062005200420032002
n Emerging markets (LHS) n Developed markets (LHS)
0E
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50EM/World GDP
EM/World Trade
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USD
)%
EM trade/world GDP (RHS)EM trade/world trade (RHS)
US RETREAT IS CHINA’S OPPORTUNITY
The US withdrawal from the Trans-Pacific Partnership (TPP)
provides China with greater scope to fill the vacuum for East Asian
and Pacific trade. It is already making a push for an alternative with
the Regional Comprehensive Economic Partnership (RCEP), a
potential free trade agreement involving the Association of
Southeast Asian Nations (ASEAN) as well as Japan, South Korea,
India, Australia and New Zealand. If signed, RCEP would
incorporate half of the world’s population and a third of its
economic output. This increasing interregionalism will also, over
time, have meaningful effects on currency trade volumes, trends
already evident for the Chinese yuan.
CURRENT ACCOUNT DYNAMICS: REGIONAL DIFFERENTIATION
Asian economies are wary of current account deficits
During the 1990s many Asian economies became reliant on
inflows of foreign capital, building up large current account deficits
in the process. When investor confidence collapsed in 1997 these
capital inflows reversed abruptly, sparking a balance of payments
crisis. The IMF subsequently stepped in to provide support,
conditional on these countries exercising fiscal austerity and
monetary restraint. This prescription proved controversial
however and made these economies determined to never again
be beholden to the IMF. Since then, South East Asian economies
have become much more savers than spenders.
Latin American current accounts are commodity-sensitive while EMEA’s are a mixed bag
Major commodity-exporting Latin American economies
maintained large current account surpluses during the 2000s
thanks to very favourable terms-of-trade linked to the so-called
‘commodity super-cycle’. Its end in 2011 resulted in deteriorating
terms of trade and a reversal of these surpluses into deficits.
Europe, Middle East and Africa (EMEA) economies vary
considerably in terms of their external sensitivity. Some of the
more commodity-driven economies, notably Russia and Middle
Eastern oil exporters, have seen substantial swings in their current
accounts which goes some way towards explaining the
characteristics of their fiscal and borrowing strategies.
PUBLIC DEBT LEVELS IN EM REMAIN SIGNIFICANTLY BELOW THAT FOR DM ALTHOUGH THEY ARE ON A RISING TRAJECTORY
Having been below 40% just eight years ago, EM government debt
is now approaching 50% of GDP. Although there is considerable
variance across EM, countries such as Brazil and Argentina have
experienced significant rises in government debt levels in recent
years. Despite this, EM public debt remains markedly below the
108% level of advanced economies.
To get a more holistic view of EM’s debt picture, perhaps a better
measure to look at is total debt-to-GDP, which includes
government, corporate and household debt. Similar to
government debt, total debt is considerably higher in DM (380% of
GDP) than EM (216% of GDP). There are signs that this gap is
narrowing however (Figure 6). In addition to generally rising EM
government debt, this narrowing is being driven by China where
total debt now exceeds 300% of GDP.
Figure 6: Total debt as % GDP for EM and DM6
EM DM
30
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150
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201120041997
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%
6 Source: IIF, Insight, August 2019.
EM DEBT AS AN ASSET CLASS HAS SEEN DRAMATIC GROWTH
The EM debt asset class has experienced considerable growth
over the past two decades (Figure 7). Back in 2000, EM debt
represented just 2% of the global bond universe whereas today it
is closer to 25%. Yet despite today being such a significant part of
the global outstanding debt stock, EM debt remains considerably
underrepresented in global bond indices with of a weighting of
just 7% in the Bloomberg Barclays Global Aggregate Bond Index,
for example. This misalignment is in the process of being
remedied, with China’s accession to a number of global bond
indices.
MARKET STRUCTURE
EM DEBT HAS EXPERIENCED DRAMATIC GROWTH OVER THE PAST TWO DECADES, IN LINE WITH EM’S GROWING
ECONOMIC CLOUT. AS THE MARKET FURTHER MATURES AND BANK DISINTERMEDIATION TRENDS BECOME
FURTHER ENTRENCHED, WE EXPECT THIS TO CONTINUE.
Figure 7: EM debt as an asset class has seen dramatic growth over the past two decades7
0
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n EM local corporatesn EM local sovereignsn EM external sovereignsn EM external corporates
20182017201620152014201320122011201020092008200720062005200420032002
$bn
7 Source: JPMorgan, Insight, December 2018.
Back in 2000, EM debt represented just 2% of the global bond universe
whereas today it is closer to 25%
INCREASING BANK DISINTERMEDIATION SHOULD DRIVE FURTHER EM DEBT GROWTH
Bank lending remains the dominant source of financing in EM, in
contrast to DM where greater levels of financial disintermediation
have resulted in considerably more non-bank debt (Figure 8).
While this is largely a function of the greater maturity and depth of
DM capital markets, it is also just a manifestation of the post-global
financial crisis reality, where tighter bank regulation and increased
capital charges have forced a transfer of balance sheet lending
from banks to asset managers.
Longer term, EM should see the trend towards greater bank
disintermediation. The hard currency EM corporate debt market
serves as a good example of how this is already evolving. Just a
couple of decades ago this market was virtually non-existent with
corporates relying predominantly on bank lending. Since the
crisis, EM corporate debt has become very much a standalone
asset class. It has quadrupled in size, and at US$2.3trn now stands
at twice the size of both the EM hard currency sovereign debt and
US high yield markets (Figure 9).
8 Source: Bank for International Settlements. 9 Source: JPMorgan, Insight. 10 Source: IMF.
A CLOSER LOOK AT THE EM CORPORATE DEBT MARKET
This growth has also occurred at a time when the fundamental
quality of EM corporate debt is improving, while EM sovereign
debt’s fundamentals have marginally deteriorated (owing to
downgrades of Brazil and Turkey). The average rating for EM
sovereign debt is high yield, at BB+, whereas the average rating
for EM corporate debt is investment grade at BBB-.
In addition to enjoying a higher average credit rating, EM
corporate debt also serves as a useful diversifier. Using the
JPMorgan CEMBI Index as a proxy for the investment universe, EM
corporate debt encompasses over 60 countries across 12 sectors.
Furthermore, the ownership profile of EM corporate debt varies
quite considerably by region which contributes to lower cross-
regional correlations. Local investors tend to feature more
prominently in Middle Eastern and Asian markets, while offshore
fund investors tend to be more prominent in Latin America and
Emerging Europe (Figure 10).
Figure 10: Holders of hard currency corporate debt, by type (%)10
n Asian banks n Asian nonbank investors n US funds n European funds n Latin American investors n Middle East investorsn EM dedicated funds n Unidentified
0
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40
60
80
100
EM Asia Latin America EM Europe MENA
Figure 8: Bank lending as a % of GDP8
Developed marketsEmerging markets China
0
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Emerging Markets
United States
Advanced Economies
Jun18Jun 16Jun 14Jun 12Jun 10Jun 08Jun 06Jun 04Jun 02
%
US
Figure 9: EM corporate external bond stock (USD bn)9
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EM LOCAL DEBT (UNHEDGED) CAN PERIODICALLY GENERATE THE STRONGEST RETURNS BUT WITH GREATER VOLATILITY, MAKING IT LESS ATTRACTIVE STRUCTURALLY
EM debt risk-adjusted returns have traditionally been most
attractive in hard currency (Figure 11). While EM local currency
debt (unhedged) can, at times, generate some of the strongest
outright returns, it can also be the most volatile sub-asset class
leading to a low Sharpe ratio. Decomposing local currency
returns between spot FX performance and bond performance
(rates and carry) shows that FX has been the most volatile
component of returns, and has been a consistent source of
negative return in most of the asset class’ down years.
Given this, the structural rationale of investing in EM economies
as they improve over time has less relevance for this segment of
the asset class, although it potentially offers compelling tactical
opportunities.
MARKET BEHAVIOUR
EM DEBT RISK/RETURN METRICS VARY CONSIDERABLY ACROSS SUB-ASSET CLASSES AND REGIONS. INCOME
HAS, HOWEVER, BEEN A DOMINANT SOURCE OF RETURN OVER THE LONG TERM.
Figure 11: Return to volatility ratios (starts 2010)11
0.0
0.5
1.0
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S&P
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EM E
quity
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eign
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orpo
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10 Source: Insight, August 2019.
INCOME HAS DOMINATED RETURNS OVER THE LONG TERM
Income has tended to be large driver of returns over time for the
three EM debt sub-asset classes, while spread and interest rate
duration volatility dominate returns over shorter periods. Spread
and interest rate duration return contributions have tended to be
more amplified for hard currency sovereign debt owing to its
longer duration profile (c. 7 years) versus hard currency corporate
debt (c. 5 years).
KEY FACTORS AFFECTING EM ASSETS
EM – DM growth differential
Expectations of EM growth relative to DM typically drive asset
allocation (and returns) across all segments of the asset class.
Historically, EM assets have tended to outperform DM assets
when this growth differential is favourable. Higher growth rates
contribute towards an improvement in EM corporate and
sovereign fundamentals, which in turn attracts capital inflows and
supports asset prices.
The US dollar and US interest rates have important implications for the asset class
Whenever the Federal Reserve raises interest rates the effects are
often keenly felt in emerging markets. Higher US yields reduce the
relative attractiveness of EM assets prompting capital outflows
and depreciating EM currencies. For EM economies reliant on
external financing for government budgets or current account
deficits these outflows are most problematic.
Higher US interest rates and the stronger US dollar that typically
accompanies it do not usually bode well for EM local currency
debt, with underperformance primarily on the currency side
(weakening EM currencies). Furthermore, EM central banks might
be compelled to hike domestic interest rates to limit capital
outflow pressures, raising bond yields in the process.
A stronger dollar also has implications for hard currency EM
assets. EM corporates and banks that have borrowed in US dollars
yet whose revenue streams or assets are primarily local currency
denominated, may find it harder to pay off their hard currency
debt as EM currencies weaken. This can have negative
implications for their credit metrics and ultimately their credit
spreads. For EM local currency debt issuers, this problem does
not arise since it’s the investor in the debt that ultimately bears the
currency risks.
An evolving domestic investor base
The growth of domestic EM investors has changed the dynamics
of EM debt investing. The reorientation towards a more domestic
buyer base has been driven in part by memories of the 1990s
balance of payments crises where adverse currency moves had a
negative feedback loop on hard currency debt stocks. EM
countries want to avoid this ‘original sin’ problem by funding
themselves domestically, thereby removing currency mismatch
risks and reducing their reliance on foreign investor flows. It has
also been driven by the ongoing deepening and maturing of
domestic financial systems, with the growth of domestic pension
funds, asset managers and banks which provide demand for local
currency debt. This development brings reduced volatility as local
capital tends to be considerably more stable than foreign capital.
CONCLUSIONS
The shift in the world’s economic centre of gravity towards
emerging markets has been ongoing for much of the past three
decades. Emerging market economies now account for close to
half of global economic and trade output. While the size of the
EM debt asset class has tended to lag EM’s economic
importance, this is in the process of changing. Despite being
just a small speck in the global debt landscape twenty years
ago, today EM debt accounts for 25% of global debt
outstanding. As EM debt’s index representation increases
further and bank disintermediation trends start to catch up with
developed markets, we expect rapid growth in the asset class
to continue.
While EM debt returns have traditionally been most attractive in
hard currency, EM local currency debt (unhedged) has, at times,
generated some of the strongest outright returns. That said, EM
local currency debt also tends to be the most volatile sub-asset
class leading to a low Sharpe ratio, making this segment of the
asset class less attractive structurally. Income has tended to be
a large driver of long-term EM debt returns, while spread and
interest rate duration volatility dominate returns over shorter
periods. Among the key factors affecting EM debt performance
are expectations of the emerging market versus developed
marked growth differential, US interest rates and the US dollar
as well as developments in the domestic EM investor base.
IMPORTANT INFORMATION
RISK DISCLOSURESPast performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.
Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
Portfolio holdings are subject to change, for information only and are not investment recommendations.
ASSOCIATED INVESTMENT RISKSFixed Income
Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
CONTRIBUTORS
Colm McDonagh, Head of Emerging Market Fixed Income, Insight Investment
Michael Warner, Analyst, Insight Investment
Cynthia Mar, Sovereign Analyst, Emerging Markets, Fixed Income Insight Investment
Derek Traynor, CFA, Senior Investment Content Specialist, Insight Investment
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