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For emerging markets debt, countries are what count
Matthew Murphy CFA, CAIA, institutional portfolio manager, Eaton Vance
EMERGING MARKETS RENEWAL After a disappointing 2018, investors have rediscovered their appetite for emerging markets debt (EMD). Performance for the asset class is sharply rebounding, led by the local currency EMD segment. Returns on local currency bonds registered 5.5% in Jan- uary alone, a level that made up for much of the ground lost last year.
Strong demand helped to boost total returns, with net inflows reaching US$17.1bn in the first seven weeks of 2019. That allocations are rising to the sector is not surprising. Valuations appear compel- ling on the heels of last year’s declines, and local currency EMD offers one of the most attractive yields available in fixed income markets at 6.25%. Meanwhile, the headwinds that battered the sector in 2018 have been gently abating. The US Federal Reserve pushed pause on hiking interest rates at its January meeting, chart- ing a more accommodative course that should lift pressure from emerging markets currencies.
In the US political arena, the focus is turn- ing inward in the long run-up to the elec- tions in 2020. President Trump is more pre-occupied with domestic rather than for- eign affairs and external issues, such as trade talks with China, have made modest progress. Comparatively hawkish emerging market central banks and expectations for benign inflation across much of the EMD universe further reinforce our positive outlook for local rates and currencies.
Put simply, we are as optimistic on the pros- pects for local currency EMD today as we have ever been. However, global macro risks like slower growth, ongoing trade wars and renewed Fed rate hikes could always reassert themselves and fundamentals remain a concern in some key countries.
COUNTRIES ARE WHAT COUNT When investing in emerging market debt, we believe countries are what matter most. Clearly, as we have just hinted at above, there is always the need for country-specific due diligence and careful evaluation of risk factors. Fundamental and political analysis are central to our approach, but we find their greatest potential for adding value is when applied to the large but under-re- searched universe of off-index countries. This is an investment area where inefficien- cies are higher, correlations to global mar- kets are lower and the opportunity set is larger. Consider for instance that the JP Morgan Government Bond Index - EM (GBI-EM) has just 19 constituents, a small subset of the larger universe of more than 80 investable local currency EMD issuers. From what we observe, most managers con- fine themselves – explicitly or implicitly – to benchmark countries. That can increase concentration risk, with the top 10 constitu- ents on the GBI-EM accounting for roughly 80% of its weight. By neglecting the wider universe, investors also forgo the opportunity to access coun- tries with idiosyncratic return drivers less affected by global capital flows. Correlations
for benchmark-listed and developed coun- tries are higher, reflecting the advent of ETFs and the effect of flows on benchmark constituents. Non-indexed countries are more insulated from global market swings. In this way, these often small and niche EMD markets can provide investors the opportunity for both uncovering hidden alpha while also dampening down volatility when market conditions become less favourable. In short, by taking a flexible approach in a broader country universe, investors increase the potential for earning more stable returns.
CONCLUSION Combined with attractive return potential, compelling valuations and high yields for local currency EMD today, improvements in the external environment have brought about a sea change in investor sentiment toward the EMD asset class. With appetite returning strongly, investors allocating to local currency EMD should carefully con- sider the design of individual strategies. It is our view that few are built to maximise the full potential for alpha generation and diver- sification available in the sector. A best- ideas, country-focused approach is not just well suited to these tasks, but also to deliver- ing attractive risk-adjusted returns over the cycle.
Sources: JPMorgan, Eaton Vance. As at 28 February 2019. For Professional Clients/Institutional Investors use only. This material is presented for informational and illustrative purposes only and should not be construed as investment advice, a recommendation to purchase or sell specific instruments, or to adopt any particular investment strategy. It has been prepared on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. Eaton Vance Management (International) Limited (“EVMI”) is not responsible for any subsequent investment advice given based on the information supplied. Past performance is not a reliable indicator of future results. This material is issued by EVMI who is authorised and regulated in the United Kingdom by the Financial Conduct Authority. Visit EVMI at
https://www.eatonvance.co.uk. JP Morgan Government Bond Index - Emerging Market (GBI-EM) Global Diversified is an unmanaged index of local-currency bonds with maturities of more than one year issued by emerging markets governments. Investing in Emerging Markets is sensitive to stock market volatility, adverse market, economic, political, regulatory, geopolitical and other conditions. Changes in exchange rates may lead to fluctuations in the value of investments. Debt securities are subject to risks that the issuer will not meet its payment obligations. Low rated or equivalent unrated debt securities of the type in which a portfolio will invest generally offer a higher return than higher rated debt securities, but also are subject to greater risks that the issuer will default. Unrated bonds are generally regarded as being speculative.
Issue 82 | March 2019 | portfolio institutional | 9
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