While emerging market equities have performed strongly since the Covid-19 sell-off earlier this year, investors may be able to find better opportunities in debt issued by developing economies instead, according to Rathbones’ Alex Moore.
The MSCI Emerging Markets index has risen by 22.16 per cent over the past six months, in sterling terms. And investors have followed the returns on offer.
Over the past year, the IA Global Emerging Markets sector has seen £310m in inflows compared with just £115m for emerging market debt funds.
Source: IA
But investors could be putting their money in the wrong asset.
Moore (pictured), head of collectives research at Rathbones, said the recovery across the various economies that make up the emerging markets bucket has been varied.
While China – the biggest constituent of the benchmark – has performed well due to its ability to control the spread of the coronavirus and provide liquidity to its banking system, it is not the same for all countries, Moore noted.
“Most economic indicators do suggest activity in emerging markets is recovering. But it is uneven across economies,” he said. “And we think that normalisation is much less visible where countries have had a real problem with controlling Covid.”
With leading indicators suggesting that the recovery could be losing impetus or is weaker than perceived, investors need to consider how equity strategies are positioned for a drop-off in global growth or any new trade disruptions.
As such, Moore said there are greater opportunities in emerging market debt, with the repayment crises of the past “highly unlikely”.
“In emerging markets – and especially the major emerging markets – there is no immediate need to rely on bond financing whatsoever,” he explained. “They do have reserves available to utilise.”
In addition, they have been engaging in quantitative easing. While this has been common in developed markets since the global financial crisis, it has not been practical in emerging markets, which have suffered from runaway inflation in the past.
“The reason for that is investors are usually concerned about how inflationary QE [quantitative easing] can be in emerging markets, and what bearing that might have on their investment returns,” Moore said. “What we've observed was, with more countries doing QE in emerging markets, the inflationary expectations of the past are not there. If anything, inflation expectations remain quite subdued.
“So, a lot of emerging market central banks have been taking advantage of this. They've been providing liquidity to the financial markets and banking systems, cutting interest rates and doing bond buybacks.”
As such, policymakers have more monetary tools at their disposal to control economic volatility, which has traditionally hampered emerging markets.
“If that's the case, what you may find is that spreads have further scope to tighten from here,” he said. “You may also find that from a structural perspective, they could potentially reach new lows.”
There are also risks, Moore noted. It remains to be seen whether quantitative easing will become inflationary, while the strength of the US dollar may affect returns.
“We think that, given where we are with our starting levels today, given the policy actions of central banks in emerging markets, and given how market participants have responded to that compared with what we've seen in previous bouts of economic volatility, there is actually some spread capture to be had here,” he said.
“That can be particularly useful at the time when investors are looking for yield and may find it difficult to come by through the traditional means of investment-grade credit and equities.”
Performance of sectors over 6mths
Source: FE Analytics
For investors willing to take on more emerging market debt exposure, a blended approach – a mix of local and hard currency – may make sense, according to Moore.
“Historically, local currency issues have tended to be more volatile and with that volatility they have tended to be impaired with economic uncertainty and tended to have more drawdown,” he said.
Nevertheless, picking the right fund is crucial, as the spread of return in the three emerging market debt sectors has shown this year.
“Some funds will target local currency or hard currency and because of that, you will get varying degrees of return,” he said.
“There are also funds out there that position for duration and some out there that don't. And if you've got a short-duration issue, historically, that's meant low volatility. Well, what has happened this year is that because there was a big pursuit of cash and liquidity in Q1 in response to the pandemic, many investors were selling their most liquid fixed income first, which has a tendency to be short duration.
“So, actually, short-duration bonds lost money this year.”
Ultimately, it comes down to investors’ risk appetite, Moore said.
“Local currency bonds are more volatile but higher-yielding, while hard currency tends to be low yielding and less volatile,” he finished. “And short duration – with the exception of this year – you get more certainty, [it is] less volatile and you get less capital return, but you also get less income as well.
“So, the spreads of funds' [performance] you're seeing on any one time period you're looking at could be a combination of any one of those things.”