Now is not a “great time” to buy into emerging market debt but, over the medium term, fundamentals in the asset class are becoming increasingly positive, according to Schroder’s James Barrineau.
The co-head of emerging markets fixed income at Schroders says US dollar strength presents a headwind for local currency denominated debt, but believes markets are on the verge of a significant inflection point.
Performance of currency vs sterling in 2016
Source: FE Analytics
He reasons that the rallying US dollar – which reached a 14-year high this morning following the US Federal Reserve’s decision to hike rates – will at some point mean revert and present an attractive buying opportunity within emerging market debt. 
“When you get a strong dollar, that is maybe the worst single thing for emerging markets. What happens when you have a strong dollar is it sucks liquidity out of emerging markets and into the US, whether it’s through foreign direct investment or equity inflows when rates in the US rise, all of that hurts asset prices in emerging markets,” Barrineau (pictured) explained.
“But, when US growth rises, emerging market growth is going to rise off the back of that as well.”
“We’ve had a really aggressive divergence between fundamentals, so I’m not going to stand here and say it’s a great time to invest in emerging markets because it’s not, given the US dollar is rising.
“But, we could get to an inflection point in the US dollar when it gets high enough.”
Since the US election last month, the manager says there has been a significant divergence between the performance of the S&P 500 and the MSCI Emerging Markets indices.
While the emerging markets sector was favoured during the first half of the year, the increased likelihood of fiscal loosening under a Trump presidency has reduced investors’ interest in the sector.
Performance of indices since US election
Source: FE Analytics
“The key thing to think about as to why this happened is the whole notion of the market anticipating higher US growth, higher US inflation and higher rates, which means the US dollar strengthens. That’s what we’ve seen pretty relentlessly ever since the election,” Barrineau said.
“So that’s all great stuff for US high yield but it’s not necessarily good for emerging markets. That kind of scenario is good for emerging market fundamentals and, even before the election, emerging market fundamentals were pretty okay.
“Growth in emerging markets is pretty good, inflation is coming down, we had a period in 2016 from January to near to the election where emerging market commodities had a great run. That allowed central banks to cut interest rates.
“The key thing you have to remember is fundamentals and asset prices are two separate discussions.”
Barrineau isn’t the only industry professional to believe economic fundamentals within emerging markets are strengthening.
Richard Turnhill, global chief investment strategist at BlackRock, says risks for emerging market equities and bonds have indeed increased since the US election. However, he believes a cyclical growth pick-up benefitting emerging markets outweighs these risks for now and supports selectively investing in emerging market assets.
“Emerging market assets have stabilised somewhat but lagged a recent rally in commodities. Our conviction is that US-led reflation – rising wages, nominal growth and inflation reinforced by an expected shift to fiscal stimulus – should be a big positive for many emerging market assets. Greater infrastructure spending should boost demand for the commodities exported by emerging market producers,” he said in his latest weekly commentary.
“Risks abound in the short term, including a sharper rise in US Treasury yields and the US dollar as well as a quicker fall in China’s yuan. But we believe a gradual Federal Reserve, wary of tighter financial conditions, should limit dollar gains from here.”
While many believe that emerging market debt is higher risk than developed market fixed income, Barrineau argues that a small price move in developed sovereigns wipes out years of carry.
This is because the higher the asset’s rating is, the lower its yield and therefore the greater the possibility is of producing a negative real return.
“When we have QE and we have all the developed markets with no yield whatsoever and you get a rate sell-off like we’ve had over the past month or so, you lose a tremendous amount of carry in those bonds because you have no yield to protect yourself,” the manager explained.
“So emerging market debt is considered to be very, very risky but developed market debt offers you no protection against very small prices rises. A one per cent price drop in most of the developed world rated ‘A’ or above takes years to make up the yield move. In emerging markets this is more mitigated by the fact that yield is higher in emerging markets.”
Another reason he believes emerging market debt looks attractive from a fundamental perspective is that the sector’s growth outpaces developed countries.
According to Barrineau’s data, 10 out of 13 major emerging market economies are forecast to grow twice as much as Japan in 2017. A further four out of these 10 could be set to double the growth of the US over the same time frame.
Historical and forecast levels of growth across emerging and developed economies 2015 to 2017
Source: Bloomberg
“What’s interesting about emerging markets is the fall in commodity prices, political turmoil and changes in economic routine caused terrible, terrible recessions in 2015 in Russia, Brazil and Argentina,” the manager said.
“So, the greater change when those recessions become less severe and then eventually turn into causes of growth is going to be very positive for emerging market growth in aggregate.”
“So if you added up emerging market growth in aggregate and developed market growth in aggregate, emerging markets are going to grow twice as fast as developed markets in 2016 and 2017. That’s a really good thing to keep in mind because that helps with debt levels.”
However, not everybody believes emerging market debt will be favourable as we head into the new year.
Neil Williams, group chief economist at Hermes Investment Management, says that potential trade wars in some emerging market economies as well as deflationary and leveraging risks should be closely monitored by investors.
“For those non commodity-exporting emerging markets with high exposure to short-term US dollar debt and/or foreign saving needs, the outlook’s less rosy,” he warned.
“For these countries, clear vulnerabilities exist. But, for others, external debt-ratios are lower, with fewer currency pegs to have to protect. And, where domestic debt climbs, they too can run QE.”
To counteract such potential risks, Barrineau says it is vital to invest across the different sub-asset classes within emerging market debt. For example, his Schroder ISF Emerging Market Local Currency Bond fund is benchmarked against an equal weighting of local currency-denominated, sovereign and corporate bonds.
At any one time, he points out that each area of emerging market debt struggles and thrives in varying macroeconomic conditions.
“When you look at emerging returns it’s very deceiving to talk about emerging markets because it’s matured as an asset class, there are lots of different things you can do within emerging markets, there are a lot of different pockets of opportunities,” the manager said.
“So today is probably not the greatest day to invest in emerging markets but, as US high yield and other asset classes that are more US-centric rally and emerging markets sell off, the relative value is starting to look more attractive. So one of the key things we’re looking for is a turn in the US dollar and a weakening of the conditions that are making the US dollar strong.”