Emerging Markets
For a while now we have been favorable toward Emerging Markets (EM) allocations based on a multi-factor analysis. The convergence of relative lower valuations, improving fundamentals and low institutional allocations pointed toward a long-term opportunity.
We have been especially interested in EM fixed income – sovereign and corporate – in recognition of the fact that the macro-economic upcycle that is developing as the world reopens after a year of COVID combined with stronger balance sheets created a classic value opportunity. Leverage on balance sheets is significantly lower in EM issuers relative to Developed Markets (DM) issuers. This is due to the fact that the fiscal response of Emerging Markets has been a lot more muted than what experienced in the USA or Europe; such framework provides a cushion when rates will start to rise as DM finds itself to the limit of fiscal and monetary support while EM have significant margins.
From an institutional perspective, we see a chronic underrepresentation. For instance, PIMCO reports that EM debt only represents 2% of US life insurance companies’ bond portfolios. This is occurring in a market that has grown in the last 20 years from $60 billion of Investment Grade paper to $2 trillion. A “home bias” is often present in allocations and it may also reflect objective external risks that a money manager might have difficulty quantifying. However, we also note that default rates are nearly identical between EM and US corporate bonds. PIMCO quotes that in the last 10 years, default and recovery rates have greatly improved in EM versus DM and recent studies are showing that recovery rates are actually higher in EM than in DM.
Naturally there are risks associated with a step into EM bonds such as country risk in general (i.e. Russia invading Crimea was an unexpected geo-political development) and currency risk. The latter can be an issue even when the bond is denominated in US Dollars if the issuer earns most of its cash flow in local currency. Such a currency mismatch between liabilities and cash flows was at the heart of the 1998 Asian crisis. However, this seems to be a much smaller issue these days as especially large cap companies have dramatically improved their ability to earn revenues globally reducing their foreign-exchange liability.
In brief, we believe that the value opportunity remains and that the residual risks associated with EM investments can be smoothened by a properly diversified approach.