In 2014, my colleague Larry Cao, CFA, wrote an excellent primer on assessing emerging market fixed-income investments. In his piece, Larry pointed out that most investors invest in emerging markets fixed income as beta opportunities. That is, investors frequently trade emerging markets as a block, failing to make distinctions among regions, and especially among individual countries. In my opinion, when the perception of investors is that risks are low in emerging markets, then there are alpha opportunities — and when risks are seen as high, there are only beta losses.
To better assess the current bill of health of emerging market fixed income, I am going to borrow Larry’s succinct, yet informative, framework. In short: it is stormy out there!
Larry’s framework for understanding emerging market fixed-income investments focuses on assessing these three factors:
- Country risk: Driven by nations’ fiscal and geopolitical conditions relative to the developed world, typically. Important factors examined include government budget health, per capita gross domestic product (GDP) growth, unemployment rates, relationship with neighbors, access to natural resources, and so forth.
- Currency risk: Driven by balance of payments, external balances, currency reserve positions, and so on.
- Corporate credit risk: Driven by individual companies’ business models, capital structure, ability to generate consistent cash flows, etc.
Among the emerging market nations currently experiencing poor fiscal conditions relative to parts of the developed world, most notable are the economies dependent on commodities pricing (Think: Russia and the OPEC nations). For each of these regions, vast proportions of their fiscal health and government budgets rely on high oil and natural gas prices. The commodities rout is also affecting developed nations, too, such as the United States and Canada. But both of these countries have broader economies than the developing nations and are not feeling the pain acutely. Fiscal conditions also appear to be deteriorating in China, where the second derivative on GDP growth is negative.
Result: Bad for emerging markets.
Demographics also drive fiscal health. In my opinion, current global demographics are very poor. First, many economically developed regions have rapidly aging populations. For example: most of Europe, China, and Japan. Given the high percentage of global GDP represented by these nations, this is potentially alarming for the developed world and good for the developing world. If nothing else, there are likely to be increased emigration/immigration pressures in Europe and Southeast Asia. Second, in the developing world there is arguably too much youthful population relative to the size of the economies. Chiefly, many of the countries in Africa, almost all of which are still developing, have large youthful proportions of population. A skeptic likely sees this as a negative, whereas I believe this is an opportunity for developing nations.
Result: Slightly beneficial for emerging markets.
Geopolitical risk is obviously highest right now in the Middle East. Yet there are growing tensions in Southeast Asia as China, Vietnam, India, the Philippines, and the United States all look to influence seaways in the South China Sea. Then there is the always enigmatic North Korea and its saber-rattling missile launches. Tensions also are high in the buffer states surrounding Russia. Last, it appears that growing tensions are likely in the southern parts of Europe due to the extended economic troubles, coupled with the refugee crisis.
Result: On balance, bad for emerging markets.
In summary, it appears to me that the current state of emerging markets at the country level is risky. Consequently, there is downward pressure on emerging market fixed-income prices.
At the time of this writing, China is expending hundreds of billions of yuan to prop up the value of its currency. In short, both domestic and foreign investors are fleeing China as its economic growth slows. In Russia, the situation is even worse, and across the Middle East the situation is also dire, given the collapse of oil prices. Sadly for most developing countries it appears that many investors are fleeing emerging markets in favor of developed nations. In other words, there is tremendous downward pressure on emerging market currencies, and hence pressure on the performance of emerging market fixed-income investments.
Result: Bad for emerging markets.
Fiscal pressures at the country level are also driving currency pressures. The combination of the two risk factors mean that there is certainly downward pressure on emerging market fixed-income pricing.
Corporate Credit Risks
There are literally thousands of companies operating in emerging markets and whose operations are separate from global economic headwinds. On the surface it may seem that this is a positive for emerging market fixed income. Unfortunately, most of the debt issues of size – the types that global investors are likely to consider – are issued by businesses directly tied to country level and currency risks. However, if you are a long-term investor, the ability of a credit to pay its bills is the primary consideration. Encouragingly, many emerging market companies in this instance are doing very well, thank you. Not only are margins growing, but so are revenues, and cash flows. Meanwhile, leverage is lower and balance sheets healthier at the company level in emerging markets.
Result: Bad for emerging markets in the short-term, but good in the long-term.
Our job at CFA Institute is not to make specific investment recommendations, but instead, to inform. Hopefully the above framework helps you to better understand emerging market fixed income, and maybe even to make better decisions.
However, as is often the case with investment management decisions that involve tremendous complexity, expert opinion serves as a powerful compass. One such expert is Tina Vandersteel, CFA, a portfolio manager and co-head of GMO’s emerging country debt team. Vandersteel has considered several aspects of analyzing and investing in emerging market debt:
- “Deconstructing and Reconstructing Emerging Market Debt: A Bottom-Up Approach to EMD Investing” (CFA Institute Conference Proceedings Quarterly article) A methodology for determining whether investors in emerging market debt are being adequately compensated for all of the risks they are taking.
- “Opportunities in Emerging Market Debt and Currencies” (CFA Institute Webcast) A discussion of common and unique risks across emerging market external debt, local debt, and equities.
- “The Impact of Capital Controls on Cross-Border Fixed-Income Investing” (CFA Institute Webcast) A model for understanding how economies control the movement of capital into and out of their countries as a way of fighting “currency wars.”
- “Assessing Value across Emerging Debt Markets” (CFA Institute Webcast) The evolution of emerging market debt and a framework for analyzing investments in emerging markets.