James Barrineau, Co-Head of Emerging Market Debt Relative, Schroders, looks ahead into 2013:
"Emerging market debt is poised to finish another strong year of performance. Returns in each of the major sub-components of the asset class - sovereigns, corporates, and local currency - are almost certain to post double-digit returns for 2012. Given the returns generated since the end of the financial crisis in 2008, investors are positive, but understandably cautious on timing, towards what has now become a mainstream asset class.
"We believe more modest returns are on the horizon. The key to extracting the most from emerging market debt exposure will be deciding the appropriate timing and allocation among an increasingly large opportunity set.
Fundamentals remain strong
"Perhaps the biggest positive for emerging market debt investors is the deteriorating nature of the fiscal and economic fundamentals in the developed world. We assume developed countries will continue to struggle to produce adequate economic growth. Emerging markets are almost sure to outgrow them in the coming year, however, we are under no illusions that these countries will completely ‘decouple' from the rest of the world. We think that China can continue to grow its GDP in the short term around 7%, which would support the large number of emerging market countries that are primarily commodity producers. Those emerging countries most closely tied to Europe will likely struggle to grow. Asian emerging countries are likely to continue to grow at rates well above global growth. Latin America may be a mixed bag, with Mexico and Chile performing well but the rest of the region recovering only modestly.
Why economic growth matters less
"While the current ‘fiscal cliff' debate in the US seems to be driving perceptions about global growth potential in 2013, we work under the assumption that growth will be modest and unlikely to surprise sharply on either side of the range of current forecasts. Within this broad range of growth possibilities, emerging market debt investors are likely to be relatively unaffected. The history of the asset class shows time and again that global liquidity is far more important than growth in driving returns.
"Our own proprietary Emerging Market Liquidity Index shows that the correlation between our index - which includes many sources of fund flows into the asset class - and performance of either US dollar sovereign debt or local currency debt is very high. One of our highest conviction assumptions going into 2013 is that developed country central banks will remain abundant liquidity providers. Indeed, there are signs that the Bank of Japan may seriously step up its own efforts as well. While this provision of liquidity is no guarantee of robust returns, it does suggest that risks of a serious, sustained retrenchment are small.
Increasingly selective
"As the asset class has evolved, the opportunity set for investors in emerging market debt has grown rapidly. Marketable debt in both local currency and corporates has grown very rapidly, while sovereign debt has grown only modestly. Lower sovereign debt issuance is actually good news as it is a function of the strong fiscal fundamentals. This overall growth of issuance leaves investors with many more opportunities, but past performance suggests that being increasingly selective and nimble will be the best way to access emerging markets as yields compress. Each of these sub-components has widely varying characteristics so we briefly look at the opportunities within each and how we expect to approach them in the coming year.
Emerging sovereign debt: a mixture of pricey and very cheap
"Over two-thirds of the index for emerging sovereign debt is now investment grade. As such, it trades with a high correlation to US treasuries. Therefore, return prospects for the bulk of this component will be closely tied to US rates. We expect that the Federal Reserve will be buying treasuries throughout the year, limiting the downside in prices. However, a GDP growth surprise for the US would be a negative for a large portion of this universe. A second group within this component consists of a number of countries which are rated just a notch or two below investment grade. This basket of countries offers both reasonable yields and some diversification away from US interest rate risk. A third tier consists of countries like Ukraine, Argentina, and Venezuela. These countries offer yields well above other sovereigns and comparably-rated global credits. Each has an individual dynamic that must be analysed carefully. Exposures here should be tactical, but the global search for yield and attractive valuations suggests that, unless there is a global shock, some exposure is warranted.
Emerging corporate debt: relatively cheap, but security selection is key
"Emerging market corporate spreads are still wide relative to developed market credit, so there remains some scope for broad market positive performance. However, low current absolute yield and spread levels indicate that the beta trade for the asset class has largely run its course. Primary market supply will remain high, challenging the absorption capacity of a growing investor base. In 2013, credit selection will be the main driver of performance, as tepid global growth will continue to exert downward pressure on credit quality. While default rates are expected to remain low, credit differentiation will intensify. While we anticipate changing risks and variable investor preferences as it relates to emerging corporate debt in 2013, the increased allocation to this sub-component is expected to continue providing welcome technical support for the asset class.
Local currency investing
"Local currency in emerging markets has attracted tremendous interest but we think returns will moderate in 2013, possibly significantly. Most of the returns in 2012 were driven by local rates as central banks slashed borrowing costs. We enter 2013 withfuture rate cuts likely to be confined to Europeans. While we don't see a cycle of rate hikes starting anytime in 2013 for most countries, further substantial rates gains are unlikely without a tailwind from domestic central banks. Therefore, the rates componentof the return from local currency investing is not likely to deviate from the averagenominal interest rate of around 6%.
"Aggressive easing within developed markets should help curb currency volatility in the asset class, but a wide divergence of outcomes is possible. European emerging markets are major index components but very highly correlated to the euro so total returns will be euro-driven. Mexico is the most freely-traded emerging currency but is also highly correlated to US equity returns. The rest of Latin America is less correlated but still very sensitive to central bank actions. Asian currencies are clearly less volatile but offer skimpy yields. More so than any other component of emerging market investing, local currency requires a nimble approach to varying conditions."
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