Emerging markets tend to be viewed as a homogenous asset class, but they are far from that. Historical, geographical and cultural differences have always existed, and their economic developments have been equally diverse. Within the EM debt universe, there are two distinctive asset classes – local and hard currency – differentiated by two major performance drivers. This is being increasingly recognised with some investors now making separate allocations to each asset. But is this the best way forward?
Our ‘scatter’ analysis below does not fully support this approach. We analysed returns over a 15-year period from the end of 2002 and discovered that, while the US dollar is a dominant determinant of EM local currency returns, movements in US Treasuries only occasionally constitute a significant driver of EM hard currency returns.
Local currency returns vs. US dollar index (DXY)
Monthly returns Jan 2003 - Dec 2017 in %
US-Dollar Returns (x-axis) are a significant driver of EM Local currency returns (y-axis)
Hard currency bonds vs. 10-year US Treasury
Monthly returns Jan 2003 - Dec 2017 in %
US-Treasury Returns (x-axis) are no significant driver of EM hard currency bond returns (y-axis)
Source: GAM, Bloomberg. Period analysed 31.12.2002 to 31.12.2017. Past performance is not an indicator of future performance and current or future trends.
Consequently, we believe that a simple asset class approach (between hard and local currency) to EM debt by making ‘building block’ allocations is sub-optimal because it is most of the time simply a call on the US dollar. Clearly, this ‘binary’ call on the greenback is fine when things are going well but will invariably lead to disappointing returns over an extended timeframe. However, from a more fundamental perspective, the obvious flaw in such an approach is that it fails to capture the disparity in returns between hard and local currency debt at the country level. This is exactly what we seek to do and firmly believe that harnessing such dispersion is a key strength of our investment process.
Historically, we have seen huge divergences between the performances of the two asset classes at the country level and 2017 has proved no exception with Turkey seeing its local currency bonds slide by around 1%, in aggregate, while hard currency securities appreciated by 12%+. Indeed, as the chart below clearly demonstrates, the disparity between hard and local currency returns at the country level (green and blue) has been higher than the disparity of the returns of each asset class since 2003.1
Why allocate on a country level?
Difference in percentage points between hard and local currency
Source: JP Morgan and GAM. Past performance is not an indicator of future performance and current or future trends.
Heterogeneous rather than homogenous
The rationale behind our own approach to investing in EM debt, and what differentiates us from many of our peers, is that we are primarily focused on the underlying countries themselves, rather than being constrained by US dollar expectations. In our view, it makes perfect sense to treat the EM complex as the heterogeneous universe that it is. This is also aligned to our skill set; as dedicated EM specialists, our expertise is firmly rooted in interpreting and analysing the dynamics of the market at a country level.
For emerging market debt investing, this approach should rest on three pillars: being unconstrained, selective and dynamic. The lack of constraint is important in avoiding the potential concentration risk associated with limit oneself to just a certain region, for example. The emerging market universe is highly diverse and a country-by-country analysis ensures that one does not miss out on opportunities. As such, our relative exposures to hard and local currency debt are purely a result of our country-by-country portfolio construction. We determine which countries we wish to invest in and then decide whether to take positions on hard or local currency securities in accordance with relative fundamentals and valuations. At the same time, this selectivity encourages us to invest only in those opportunities that we have the highest conviction in. The dynamic aspect reflects the constantly changing market environment in terms of relative valuations and macroeconomic developments.
This approach is inspired by the empirical and practical and anecdotal evidence we have gathered over the years that country-specific economic drivers and relative valuations play a more relevant role in determining its success than movements in the US dollar and Treasury yields. This gives us the confidence to harness a much bigger opportunity set than those pursuing an asset allocation approach based on US dollar expectations. We therefore feel comfortable in targeting consistent outperformance of a customised reference index comprising an equal blend of the relevant JP Morgan hard and local currency diversified indices. Moreover, since the portfolio’s risk is allocated among a broad set of investment ideas driven by heterogeneous factors, it is highly diversified and comprises far more embedded opportunities than a single factor approach.
1. The JPM GBI-EM index used to determine this was launched in 2002