The reversal of capital from emerging market equities and debt in early 2014 reminded the world of the nascent nature of capital markets in many emerging markets, despite large and growing savings. How do we think emerging market debt will grow in the next five years? In this piece, Grant Webster, Peter Eerdmans and Antoon de Klerk, who are part of Investec Asset Management’s Emerging Market Debt team, focus on return potentials, current account developments, and the growth of new asset categories within emerging market debt.
Local currency denominated emerging market debt (EMD) rallied strongly in the run-up to 2013, returning 12.2% per annum, on average, since the decade beginning December 2002. EMD was buoyed by strong fundamentals, a resilience of emerging markets to the developed world’s credit crisis and the quantitative easing-driven hunt for yield. Arguably this rally had pushed valuations into expensive territory especially as, on the margin, fundamentals had deteriorated.
Additionally, strong domestic demand and a reversal in commodity prices had eroded current account balances and, in some key economies, pushed current accounts into deficit.
During the summer of 2013 sentiment drifted and, after many years of inflows, emerging markets started experiencing significant outflows. Market participants feared that easy global liquidity had led to asset bubbles and diminished the momentum of structural reforms. EMD sold off as yields rose from historically low levels, while currencies also weakened.
This market reaction highlighted that a long-term sustainable approach to investing is crucial in the development of local EMD markets. The key questions we want to address are: where we are now and what we can expect from investing in local EMD on a five-year view? Have markets overshot towards cheap levels?
What might be deemed to be “fair value”? What returns can we expect as markets revert to these levels over the medium term? In particular, we will analyse the long-term growth potential in emerging markets and what this means for long-term real yields. We will also analyse if we can expect continued improvements in inflation and what the equilibrium levels for currencies might be based on our adjusted Balassa-Samuelson/PENN State valuation work.
“EMD was buoyed by strong fundamentals, a resilience of emerging markets to the developed world’s credit crisis and the quantitative easing-driven hunt for yield.”
Structural real GDP and what it means for real yields
Central to any discussion on the “attractiveness of a financial asset” is its ability to generate economic returns. The attractiveness of an investment in any company is, of course, greatly influenced by its potential to return cash to investors. Similarly, the attractiveness of an investment in the debt and/or currency of a country is greatly influenced by its potential to generate economic growth.
Furthermore, strong theoretic and empirical evidence exists on the positive relationship between real economic growth and real interest rates – clearly important for bond returns (see Figure 1). The first chart shows the average 5-year interest rates and GDP growth rates for a range of developed markets (DM) between 1975 and 2013. Emerging markets have demonstrated a similar relationship over the past 10-15 years.
One important difference, however, is that yields in emerging markets have generally been lower than their GDP growth rates may have implied. More recently, this has been a function of the economic environment, namely higher global liquidity driving yields lower. However, over the longer term the reason can be found in savings rates, which have been much higher in emerging markets than in their developed market counterparts. The specific reasons for this difference remain contested, but generally it is thought that this is due to an underdeveloped credit sector and a lack of social safety nets – specifically, no state pension, underdeveloped insurance markets and poor basic healthcare, which leads to the need for self-insurance through saving. In fact, it could be argued that developed markets were in a similar situation in the post-World War Two period, with the same phenomenon experienced in their bond markets, as highlighted in the third chart in Figure 1.
Long-term inflation expectations
Since New Zealand first initiated inflation targeting in 1990, at least 50 countries and monetary unions have incorporated inflation targets into their monetary policy framework, a large number of which are emerging markets. This has had the effect of bringing down both inflation and the volatility of inflation across emerging markets as can be seen in the graphs below.
There is reason to believe that inflation may continue to fall structurally lower in EM. Generally, there is a relationship between the level of inflation and the level of national income which we can observe empirically by looking at countries that have moved from low GDP per-capita levels to those associated with developed markets. In Figure 12, we can clearly see the pattern of lower inflation as income per capita grows.
Of course, the direction of causality here is likely to run both ways: certainly higher incomes are associated with a higher quality
institutional framework, political stability and a more developed and diversified economy – all of which are elements of long-term sustainable growth.
But lower, more stable inflation also lowers nominal interest rates, reduces the volatility of interest rates, attracts capital and makes long-term investment more predictable and attractive. These are then part of a positive feedback loop towards lower and less volatile inflation.
Higher incomes also lead to inflation baskets, which have less exposure to food and transportation, both of which have a higher sensitivity to energy prices and currencies and thus tend to have more volatile prices. More developed countries have inflation baskets that are skewed towards services, medication, personal care, culture and education, all of which have more stable prices. We show the baskets of selected EM in Figure 13.
“For these reasons we believe it is likely that EM will continue to experience lower inflation going forward, and through the cycle.”
For these reasons, we believe it is likely that EM will continue to experience lower inflation going forward, and through the cycle. At the same time we expect that the differential between EM and DM is also likely to contract as central banks in developed markets continue to target higher inflation through excess liquidity provision. Overall, the differential between EM and DM inflation has been around 3% over the past decade, where we believe this could drop to around 2%. Assuming average inflation for DM of 1.5-2%2 is repeatable into the next decade, a fair assumption for EM inflation would be 3.5-4% which is very much in line with the IMF’s expectations for inflation over the coming five years.
Bringing it all together
As highlighted before, local currency emerging market debt is driven by bond and currency returns. These returns can also be seen to comprise a yield contribution, as well as capital gains or losses, which we have considered separately based on our analysis above. Over the medium term we expect real yields to average between 3.5-4.0%. This is based on our long-term potential growth estimation, as well as savings rates and the composition of these economies. As emerging markets continue on their path of development we expect inflation to continue to range between 3.5-4.0%. Taking these expectations together we see a fair value yield range for nominal bonds of about 7.0-8.0%.
Our analysis of currencies reveals that they are currently about 3.5% cheaper on a real effective basis. Allowing for some resumption to fair value and additional returns from the expected higher productivity gains (based on the Balassa-Samuelson theory) leads us to expect a real effective appreciation of EM currencies of about 1% per annum over the next 5 years. Taking expected inflation differentials of about 2% into account, we would expect spot currencies to depreciate by approximately 1% per annum even though currencies themselves, including carry, should return 3% to 4% per year.
Total Return expectations
We can now bring this all together and calculate expected returns for local EMD using these inputs. Our base case assumptions are for yields to rise to 7.5% over five years and currencies to return -1% per annum on a spot basis. Obviously, as yields rise, coupons and maturing bonds that come due before the five years are over, can be reinvested at better yields. So the correct way to calculate the expected returns is to analyse the full local currency bond universe (proxied by the JP Morgan GBI-EM Global Diversified Index) on a cashflow basis, assuming a steady path of yield rises. We show the results in the table below, where we highlight our base case, but also show returns for different scenarios.
The key conclusion is that although the double-digit returns of the past are unlikely to be repeated, the future expected returns from local EMD remain attractive and positive even under more extreme negative scenarios. We believe that emerging markets remain on an attractive sustainable development path and that their bond markets and currencies will continue to benefit, offering investors a relatively attractive medium to long-term investment.
Antoon de Klerk, Peter Eerdmans and Grant Webster are part of Investec Asset Management’s Emerging Market Debt team. Antoon and Grant are portfolio managers and Peter is co-head of the Emerging Market Debt team.
1 IMF, IAM Calculations.
2 IMF data, CPI expectations, 2014.
3 J.P. Morgan, IAM Calculations.
4 The Big Mac index is good for calculating currency (mis) valuations on a like-for-like basis, but just how easy is it to buy a Big Mac in Rio de Janeiro and eat it in New York? Big Macs are a non-tradable good. Rising productivity in Brazil causes incomes to rise too, increasing demand for Big Macs, which Brazilians cannot physically buy more cheaply in the US. Comparing the average of tradable and non-tradable prices across countries makes currencies seem mis-valued on a purely PPP basis.