The emerging market sell-off over the past month has sparked concerns that that EM debt could see sustained outflows as US Treasury yields rise.
The JP Morgan Emerging Market Bond Index (EMBI) has fallen more than 4% since the start of April.
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Source: FE Analytics
However, Last Word Research data shows that European fund selectors surveyed in Q1 2018 actually plan to increase their holdings in the asset class over the 12-month period to end March 2019.
The asset class was one of the most successful in 2017 in terms of net flows and while sentiment remained positive toward emerging market debt, there are fewer buyers today than six to nine months ago, according to our research.
Dutch fund selectors were the most positive on emerging market debt with 56% looking to increase their holdings over the 12 months to March 2019; 33% plan to hold, and 11% did not use the asset class. This was a sharp jump from the previous quarter when only 25% wanted to increase, and 50% wanted to hold, and 11% did not use it.
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Source: Last Word Research
The pan-European sentiment for Q1 2018 had 23% looking to increase, 50% to hold, 8% to decrease, and 19% did not use the asset class.
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Source: Last Word Research
According to FE Analytics, the emerging market fixed interest sector within the FCA Recognised universe returned -0.31% over the three years to 30 April 2018.
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Source: FE Analytics
Heavy positioning
Marcelo Assalin, head of emerging market debt at Dutch asset manager NN Investment Partners, said the recent emerging market sell off was driven by investors finding themselves overweight in the asset class and uncomfortable with the risks such as higher volatility and the appreciation of the US dollar (which has risen more than 4% against the euro over the last month.)
Assalin told Expert Investor that despite these risks – and the “idiosyncratic noise” in core emerging market countries such as Argentina, Indonesia, Malaysia, Mexico, Brazil, Turkey, and Iran – emerging market fundamentals remained positive.
“The growth and inflation dynamics for emerging markets remain intact,” he said. “We expect growth will accelerate this year and next year.”
Moreover, Assalin said the sell-off reduced exposure and thus improved the position of those investors that have stuck with EM debt.
“Valuations are very attractive as currency spread is almost at 330 basis points and this is almost 100 basis points above the recent low and we think that this is very attractive.”
Assalin said that the sell-off had created a good buying opportunity for the asset class as it was now fundamentally undervalued.
He said following the sell-off he advised investors to return to the asset class selectively – with a smaller but long term positions.
Assalin said he was overweight in frontier markets like Egypt, Sri Lanka, Sub-Saharan Africa and Ecuador. He noted that Iraq was an overlooked market despite oil prices and production increasing.
“We expect government revenue to increase and current accounts to improve owing to higher oil export revenue, as a result, Iraq’s economic fundamental trajectory remains positive,” he said.
He said the emerging markets that he was not positive on were Mozambique and Pakistan.
Dutch wealth management firm, Persist’s senior investment adviser Bernard Janssen said that while he intended on increasing his holdings in emerging market debt he was not ready to do so.
“Something tells me we are not seeing a trend reversal. So, I believe that yield will not rise too much and that the USD will hardly strengthen anymore,” he said.
“Oil prices and the rise in Fed rates (and the already risen USD) will cool down the US economy.”
US dollar
While Assalin said the appreciation of the US dollar was a negative for emerging market countries – most of which are pegged to the greenback – he said he did not expect the dollar to continue to appreciate from current levels over the next few months.
According to a report by DWS the US Treasury bond sell-off and the stronger US dollar has been “the perfect cocktail for weakness across all riskier assets… [which has been] most pertinent for emerging markets,” particularly Latin American debt markets which have been among the hardest hit.
Ten-year US Treasuries hit their highest yield level in seven years at 3.07% this week, and had the highest two-year, five-year, and 10-year yields in all the G10, according to the DWS report.
Similar to Janseen, Spanish bank Caja Ingenieros portfolio manager Daniel Roig told Expert Investor that he had not changed his weighting in emerging market debt yet but that the USD rally had generated concerns about US dollar-denominated debt among emerging markets due to increased borrowing costs.
Argentina
Fidelity International’s portfolio manager Paul Greer said the US dollar surge was linked to the tumult in Argentina’s financial markets.
The South American country’s central bank has been forced to hike policy rates by almost +1,300 basis points to 40% to support the depreciating peso and to help cool soaring inflation expectations.
“The markets have seemingly lost patience with the authorities’ ability to manage the country’s ugly macro mix of widening twin deficits and elevated inflation,” Greer said.
“With 10-year US treasury yields recently touching 3%, investors have refocused on interest rate differentials and positioning.”
Liontrust Asset Management head of global fixed income David Roberts said it would take some time before investors felt confident Argentina was able to stand on its own feet without IMF support.
Future for EM
Roig said he believed that most of the US Treasury yield increase had already occurred.
“Most emerging market countries can continue to outperform during a gradual Fed tightening cycle, which is our base case,” he said.
“Emerging market countries with high external financing needs will suffer the most. In this scenario we think is very important to be selective within emerging market countries and active investment plays a key role, therefore we do not invest using passive investment in this asset class.”
Roig noted that he favoured emerging market debt local currency over hard currency debt and commodity-based economies to others.
“We think the asset class in general still offers attractive yields and, and as long term investors, the asset class still can offer us good performance in the long term,” he said.
Ashmore’s head of research Jan Dehn said that over the past week sentiment towards emerging markets had stabilised as investors had realised that the surge in the dollar was not a good reason to liquidate emerging market positions.
“The pullback in EM markets has increased the appeal of the EM asset class, which was priced attractively even prior to this latest bout of volatility,” Dehn said.
Dehn said he expected more pullbacks – such as the recent emerging market sell-off – over the next few years as developed markets adjusted to the end of quantitative easing.
“The only asset class to cheapen outright during the QE period was emerging markets which offer far better return potential than developed markets,” he said. “Investors should exploit temporary pullbacks to enter the asset class at attractive valuations.”
