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Ben Robins: Overcoming emerging market debt misconceptions

Asset class may not be as convoluted as you think

After a difficult 2018, many investors continue to question the rebound and the longer-term outlook for emerging market debt – largely based on a misconception it is a high-risk and high-beta investment.

Contradicting the stereotype of a volatile, higher beta asset class, many regions and sectors of EM offer defensive opportunities that can outperform other asset classes during periods of risk aversion. The breadth of opportunities in EM is one of its key strengths.

This is not to suggest volatility is not a concern. Rather, it means investors need to identify sectors and regions with lower beta track records when looking for defensive assets. Many areas of EM debt have behaved more defensively than some developed market counterparts. With many sources of 2018’s volatility still lingering in the current outlook, investors can actively seek out certain areas of EM rather than solely look at DM safe havens.

EM corporates stand out as a defensive sector due to strong fundamentals. Asia credit, which has grown substantially in recent years, has performed more in line with DM investment grade, for example. The defensive sectors of EM also offer opportunities to diversify portfolios away from DM regions with the most concerning growth outlooks and large debt accumulations.

EM is also becoming less correlated to some of the higher-risk sectors of DM. Traditionally, US high yield and EMD have displayed a degree of correlation due to an overlap of investors seeking higher yields than investment grade DM debt. However, this correlation has fallen in the past year and is below long-term averages. This demonstrates the increasing idiosyncratic behaviour of EMD.

Are there risks of a policy error?
While negative surprises in political or monetary policy can impact both EM and DM investing, an active approach can help avoid sudden sell-offs. The positive reforms in many EM countries mean most are no longer just one or two bad decisions away from a crisis. Bottom up, on the ground research can identify countries committed to consistent, market-friendly policies.

Even when significant sell-offs do hit certain EM countries, we do not believe this constitutes a systemic risk. For example, Turkey and Argentina dominated the headlines in 2018 as markets quickly lost confidence. Some investors pulled out of EM as a whole at the height of these crises as they sought safety.

However, this contagion-driven sell -off was short lived and created better long-term opportunities. An active, disciplined approach can reveal lower beta corners of EM, such as selecting Chinese state-owned enterprises likely to be less affected by sell-offs elsewhere. Furthermore, sudden downturns can create opportunities to buy cheap assets.

Impact of a mixed global outlook?
The growth of EM as an asset class in recent years means investors can find  investment opportunities in different global economic environments. While we do recognise strong growth is important for the prospects of EM, this must be kept in perspective as we see several reasons for optimism.

Many EM countries enjoy favourable economic growth rates supportive of fundamentals. Investors need to cast aside any preconceptions of EM being a single investment opportunity and look at individual EM sectors and regions.

We are confident many areas of EM can perform even if China or major DM economies cannot resurrect growth rates. Countries committed to positive fiscal and political reforms can continue to thrive. Many EM economies display a growing middle class, which is underpinning domestic demand. EM is no longer just an export-driven investment reliant on DM, or Chinese, growth. EM economies are trading with other EMs now more than with DMs.

Second, EM credit is on a strong footing. The EM corporate default rate is at its cyclical low. Issuers have relatively low debt levels and companies have been able to extend bond maturities and buffer balance sheets. Growth concerns in key global markets could also become tailwinds as central banks appear to be shifting to more accommodative policies. These shifts could suppress core DM yields, which would lend further support to EM assets.

History shows EM has consistently rebounded and rebounded quickly following downturns. After a difficult 2018, one could be forgiven for thinking it could take some time before investors regained confidence. However, EMD’s track record following periods of negative returns is for sharp upturns leading to sustained periods of positive returns.

Therefore, the strong start to 2019 should not come as a surprise. It also should not be treated as a short-term rebound. Based on both history and the strong fundamentals, we believe EM offers ample opportunity for sustained strong performance.

Ben Robins is emerging markets debt specialist at T. Rowe Price

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