Can EM Outperform Under “Normal” Market Conditions?
Emerging markets fixed income has outperformed most asset classes over the past three years as credit fundamentals have improved in the context of ideal global economic conditions. Low interest rates, hale investor appetite for risk, high commodity prices and solid global growth have fueled export expansion and rising incomes in many developing countries.
The tea leaves of the global economy are as difficult as ever to read, but it is increasingly clear that the era of low global rates is ending. The U.S. Federal Reserve appears set to hike Fed Funds for the 16th time at its next meeting; the European Central Bank raised its policy rate in March; and the Bank of Japan effectively ended its policy of quantitative easing last month, too. As monetary conditions grow tighter and take the shine off of some emerging markets carry trades, risk aversion could well revert from current record lows to more normal levels. An unexpected negative geopolitical event could also trigger a flight to quality.
Can the emerging market bond rally continue in the face of more “normal” liquidity and risk conditions that appear to be at hand?
Based on a simple regression of emerging market sovereign credit spreads against ratings, global liquidity and risk appetite, Fitch estimated that nearly half of the rally in emerging markets sovereign debt can be explained by true credit improvement. Governments have adopted flexible exchange rate policies, opened their economies up to trade and taken more aggressive stances to fight inflation. These advances have bolstered current account balances and reduced dependence on foreign financing, helping to insulate many emerging market economies from a potential reversal in capital market sentiment.
The changes have been recognized with upgrades across all regions – the average rating on emerging market sovereign debt now stands at an all-time high of ‘BB+’, bringing 40% of the index into investment grade, up from less than 10% just before the 1997 Asia crisis. Indeed, the 2:1 ratio of Positive to Negative Outlooks indicates that emerging market credit may have a bit more of a run ahead.
Yet while nearly half of the emerging market improvement story appears to be attributable to truly fundamental changes that are likely to be lasting, more than half of it is associated with reduced investor risk aversion and markets flush with liquidity, conditions that may well dissipate as the G7 raise rates.
Fitch estimates that a return to a more normal level of risk tolerance among investors would be associated with a 175 basis point rise in emerging market yields relative to U.S. Treasury Bonds. Add to that a rise of 50 to 75 bp in the yield of the Treasury Bonds themselves and it is not hard to envision the easy money conditions for many emerging market governments ending rather soon. With an average duration for bonds in the EMBI Global Index of 6.9, investors accustomed to handsome double-digit returns in recent years could be in for a shock if yields on emerging market debt do indeed rise to this extent.
Except for those with the narrowest liquidity and most limited fiscal flexibility, such a scenario is hardly a doomsday one for most emerging market governments. It would represent an important increase in funding costs, however, particularly for those still saddled with heavier bond debt burdens despite more pronounced improvement in external indicators.
In a recent study, the IMF found that the fiscal impact of a 300bp rise in funding costs would be greatest for sovereigns in Latin America and Emerging Europe where it would average 1% of gross domestic product, while Asia Pacific emerging markets would face increases about half as large. Those that rely more on multilateral borrowing would be less affected, but a general trend toward higher interest expenses could still materially affect the path of future credit improvement for emerging market sovereigns across the board, dampening the generally bullish current outlook.
Given that the shock is considered merely a return to something close to “normal” capital market conditions, it highlights the importance of examining just how well policymakers in specific countries have been taking advantage of today’s ideal setting to insulate themselves from an inevitable return to a world in which investors demand significantly higher premia for exposure to emerging markets debt.
Tighter liquidity conditions and incipient global inflation pressures could also present challenges for many relatively new monetary policy regimes that have just recently begun targeting inflation instead of the exchange rate. Where authorities lag is in reacting to shifts in money demand brought about by a changing external environment, volatility in local interest rate and exchange rate markets could increase substantially. For the many emerging market investors who of late have felt emboldened to seek higher yields or exchange rate plays in local fixed income, these more complex dynamics are likely to bring surprises.
Seasoned emerging market debt portfolio managers can be expected to distinguish themselves more in this environment as the performance of individual country exposures becomes increasingly differentiated. But those that joined the rally hanging from the horns of the bull may be in for a bumpy ride.
Contributor Morgan Harting is senior director of Sovereigns for Fitch Ratings. The views expressed in this article are his own and are not necessarily those of Fitch.