What drives emerging market debt returns?Aug 28, 2018

To understand what drives emerging market debt returns, investors need to examine each country on a case-by-case basis. Local politics, monetary policy, and economic fundamentals are all important when searching for investment opportunities. However broader factors can also influence the asset class more holistically. As the table below shows there are certain external factors like the US dollar, US interest rates, bond market volatility and commodity prices that can influence the performance of the index.

Correlation of broad factors to emerging market debt local index

There are economic rationales for these relationships. For example, as interest rates move higher in the US, global liquidity tends to decrease, which can create headwinds for emerging markets. A stronger USD also puts pressure on countries with large USD-denominated debt, who now have debts that are more expensive to pay back. Higher volatility tends to promote a flight to quality, which often means a flight out of emerging markets and into developed markets. And finally, the popularity of ETFs has allowed more participation by retail investors in this space, which can contribute to a herd mentality that tends to reinforce these relationships.

Of course, many of these factors are interrelated and the correlations can break down, but it is a useful starting point when analyzing the opportunities in one’s broad allocation to emerging market debt.

Country Differentiation

Country-specific factors also have a large impact on emerging market performance, as nations with relatively better economic fundamentals have suffered less deterioration during international shocks*. Key components of our analysis include looking at variables like current account deficits, fiscal deficits, external debt levels, and inflation. Considering whether a country is a commodity importer or exporter is another potential differentiating factor. Country-level analysis creates opportunities for an active manager to avoid “problem” countries and take advantage of broad selling that tends to create opportunities in countries that have better fundamentals or are improving. The adage of “throwing the baby out with bath water” is relevant.

The framework created by our Templeton Global Macro team provides a good example of how to identify opportunities in specific countries. Their proprietary Local Market Resiliency Index (LMRI) is the starting point for analysing potential investment opportunities. LMRI scores using five factors: (1) policy mix, (2) lessons learned, (3) structural reforms, (4) domestic demand, and (5) external vulnerabilities. The higher the LMRI score, the more attractive we find the country’s debt.

The role of trade

Many Emerging-market countries also rely heavily on global trade, and a handful of countries that are tightly linked to global supply chains are especially exposed to the risk of trade issues. Increasing tariff costs and depreciating currencies could potentially effect inflation rates, forcing Emerging Market central banks to hike rates, which could further impact growth.

Although there has been some detente with Europe and even Mexico (for now), our view is the US – China trade conflict will last a while longer, making emerging markets vulnerable.

Conclusions and Positioning

On the trade front we are concerned negotiations between China and the US may get worse before it gets better, which would likely be a headwind for emerging market debt. With the US economic growth and inflation recovering, late cycle fiscal stimulus and a tight labor market we think the Federal Reserve will continue raising rates gradually, a catalyst for tighter liquidity which historically is a headwind for the asset class.

The recent selloff is creating more attractive valuations and some country specific opportunities are appearing. It’s a little too early to aggressively overweight emerging market debt in our view but certain pockets of the asset class is getting more attractive.

We should note that generally within our allocation to emerging market debt, we prefer an active manager rather than using passive benchmark vehicles for our exposure. Passive vehicles are forced to hold all the countries in the index without regard to individual country fundamentals or idiosyncratic risks potentially leaving investors exposed to undue risk.

*Source: Federal Reserve Paper, “International Financial Spillovers to Emerging Economies: How Important Are Economic Fundamentals?” April 2015

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.