Much has been made of the impressive performance of emerging market equities over the last decade. What is often overlooked is that emerging market debt markets delivered a comparably high level of return – for much less risk. The steady stream of interest income helped smooth returns and deliver risk-adjusted performance superior to that of an equity investment.
Many people still think of emerging market debt as high risk. The echoes of the tequila crisis, Russian debt default and Asian financial crisis
still ring out. Few realise that close to 60 per cent of the EMD index is of investment-grade quality.
Granted, much of the sovereign debt is still at the low end of the investmentgrade scale and some countries still rank below investment-grade. This means there is still a greater risk that principal and interest payments may not be made than with more developed market issuance.
But emerging markets have learned some valuable lessons over the past 25 years. Many have implemented reforms to make their financial
systems much stronger and their governments more stable. Countries that were once extremely risky now have more independent central
banks, floating exchange rate policies and greater fiscal restraint.
A weak dollar has made it easier for developing nations to repay outstanding dollardenominated debt
Nowadays, the JP Morgan EMBI global index is rated Ba1/BB+. I reckon 2010 may be the year it achieves an investment-grade rating.
Experience gained in countries such as Brazil, which was upgraded to investmentgrade status in 2008, shows us the step-change improvement
to spreads on sovereign debt that brings and how that benefits investors.
However, before we get too carried away and overly bullish, let’s not forget that the rally in global markets has been liquidity-driven and that we have seen most risk assets outperform.
As the rally matures, attitudes towards risk may change and the gap between winners and losers may become more pronounced. In EMD, that can lead to some quite pronounced differences in performance. Even without that, we could see some outflows if the developed world sees further economic weakness and, again, responds with a flight to safety – a flight to repatriate assets to home markets.
But while I think the risk in emerging markets is priced in today, I do not yet feel the deteriorating fundamentals of the developed world are correctly reflected in markets.
We must keep an eye on policy, especially in regard to US interest rates (with the consequent effects on dollarpegged economies and exchange rates in general). The inflation/deflation balancing act is also one to watch.
If inflation becomes a greater issue for the world at large, developing nations should, however, benefit as investors turn to commodities and natural resources as a hedge against rising prices.
Many developing nations have already taken advantage of the run-up in commodity prices to build sizeable cash resources. Savings rates in the developed world were falling before the credit crunch but emerging nations have been consistently saving more and borrowing less.
Public debt to GDP in the emerging markets is expected to remain fairly stable, while we all know how it is set to rise significantly in the countries of the developed world.
Meanwhile, a world of historically low interest rates has made it cheaper for developing countries to issue new debt and the weak US dollar has made it easier for developing nations to repay outstanding dollardenominated debt and to refinance this with localcurrency-denominated issues.
The net result of all of this is that many emerging nations have left the global slowdown in a very strong position.
Now, as the economic balance of power looks like it may be shifting towards emerging markets, the next decade looks just as enticing as the one just gone.
John Carlson is portfolio manager of Fidelity Funds emerging market debt fund