In the last three months of 2020 that flow picture has reversed sharply, and is projected to continue into next year. The asset class remains under-owned relative to other asset classes and relative to its own history. Very attractive yields and less stretched valuations are likely to drive rotation out of developed market fixed income and other areas.
In addition to the technical drivers, there are key structural tailwinds that can drive EMD into next year and beyond. Vaccines and the end of the pandemic are key for all risk assets, but on a relative basis even more so for emerging markets, who don’t have the deep pockets and reserve currency status of many developed markets, and can’t all take the same extraordinary steps to protect companies and jobs.
Another tailwind is US politics and policy. The Biden presidency is likely to lead to a calmer and more predictable US foreign policy and although we don’t expect US-China tensions to disappear, the effect on global trade and the emerging market complex should be positive. Even though some investors’ expectations of a democratic “blue sweep” didn’t materialise, the US government is likely to arrive at some form of fiscal package. The Federal Reserve continues to indicate it is going to keep up extraordinary stimulus measures until inflation is at or above target. These measures are likely to cause further dollar weakening, which can support emerging markets.
The other crucial tailwind for EMD relates to the asset class itself. Emerging market countries’ management of their own economies and balance sheets is much better than it used to be. Local funding markets have become much broader and deeper, allowing countries to fund themselves in their own currencies to a much greater extent. That reduced reliance on US dollar funding reduces the mismatch between countries’ assets and liabilities and reduces the potential for crises and contagion. In addition, leading economic indicators have picked up in recent months, and reform agendas are advancing in key countries.
EMD is a $23 trillion asset class with a remarkable degree of diversity. It includes over eighty countries across nearly every continent. There is a remarkable degree of differentiation in the economic fundamentals and stability of those countries, from some of the wealthiest in the world with the healthiest reserve balances, to countries whose fiscal probity and solvency is much weaker.
The Emerging Market Corporate bond market is even more diversified than the developed world. It includes companies whose credit quality is in line with some of the strongest in the world, but just happen to be located in an emerging market jurisdiction, which lets investors access quality assets at a yield premium. At the other end of the spectrum investors can access higher yielding companies that can offer attractive returns in a yield constrained world, if associated risks are understood and managed.
For investors asking how to access EMD the answer is firstly that active management with rigorous fundamental analysis is the best way to choose between the huge range of different opportunities in this diverse asset class. The fewer constraints on which countries and companies you own and which you avoid, the better. Secondly, we’d argue that the days when investors saw EMD as a high risk, opportunistic asset class to come in and out of are over. Given 90% of the fixed income universe yields less than 3%1, a permanent allocation to EMD is one of the few ways for investors to get a decent level of yield. Furthermore, the overall quality and governance of the asset class is much better than it used to be. Finally and on a related note, a risk aware approach can limit volatility and provide a much better experience through future sell-offs.
1 Bloomberg, 31 October 2020
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at