Emerging Markets : Attractive premiums and real rates
19 April 2018
Genuine return potential on emerging local debt.
After three years of adjustment (2013 to March 2016), the emerging economies are back on track in terms of economic activity, account balances (both domestic and external) and the accumulation of reserves.
The macro outlook for 2018 is positive, with growth expected to be higher than 2017 across all of the emerging countries (5% in 2018 after 4.8% in 2017, according to JPMorgan). The rebound from 2017 appears to be strongest in Latin America (2.8% growth projected in 2018, vs. 1.7% in 2017). Inflation is under control across all of the emerging markets (3.3% average EM inflation in 2017; 2.9% in Brazil, 2.5% in Russia). Finally, public debt levels remain very low compared to the developed countries.
Our macro scenario for this asset class is positive.
Despite highly promising prospects for emerging fixed income, the uncertain future of trade agreements like NAFTA, fears of a trade war due to protectionist measures and threats by the United States and anticipations of faster policy normalisation by the Fed have all put a damper on the initial outlooks in recent weeks.
We now believe that the markets have priced in these concerns, and that they are unlikely to fundamentally alter our baseline scenario.
Our investment strategies focus on debt in strong currencies (EUR and USD) as well as local fixed income with or without foreign exchange risk, as the case may be.
The risk premium on USD foreign debt currently stands at around 3% according to the JPMorgan Global Diversified Index. The historical average (2004-today) amounts to 3.25%, with the lowest point (1.67%) reached in June 2007. This risk premium is currently equivalent to 53% of the return on this asset class. In an environment of low core interest rates, bonds in strong foreign currencies offer additional yield on country risk, with solid fundamentals.
Local sovereign debt is even more attractive, representing a rapidly growing market across all the emerging countries. In real terms2, local yields are mostly positive, ranging from 1% to 5%. The yield curves are often steep, offering more opportunities on the intermediate and long portions. These strategies may be hedged for foreign exchange risk; in this case, they would benefit exclusively from modified duration risk. Otherwise, they could be supported by foreign exchange risk and would also benefit from a highly attractive nominal carry.
Emerging market currencies were the adjustment variables for the emerging economies over the 2013 2016 period. Many of them are currently undervalued in terms of real effective exchange rates. As a result, they represent genuine return potential in view of these countries’ satisfactory economic performance.