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EM Debt: Avoiding polarised outcomes

GAM Investment’s Enzo Puntillo notes the fact hard currency bond returns typically perform in accordance with the US dollar and this therefore tends to lead to polarised return outcomes.

Tuesday, May 22, 2018

How to capture the opportunity

Thus far in 2018, emerging market (EM) debt has taken a pause to consolidate following particularly strong performance in both 2016 and 2017. However, in our view, the return of volatility to capital markets seen this year, following an unusually benign period, should not signal the end of the EM rally; we believe it could still have three or four more years to run. If this proves to be the case, the big question for investors is how to best capture the opportunity.

Typically, EM blend debt portfolios are constructed using an asset allocation approach which prescribes targeted allocations to hard and local currency bonds in accordance with US dollar expectations. Typically, hard currency bonds will outperform during periods of dollar strength and vice versa. The problem with this approach is that it tends to deliver polarised return outcomes – since it is effectively a single-decision model, the manager can only be right if he or she is right on the US dollar, and this is almost exclusively a factor of market timing.

Investing at a country level

It is both intuitive and rational to suggest that an approach based on multiple investment decisions, should reduce the emphasis on market timing, deliver more consistent returns and provide a greater diversification of risk exposures. As dedicated EM specialists, our expertise is firmly rooted in interpreting and analysing the dynamics of the market at a country level and this is reflected in the way in which we manage our clients’ assets. We decide which countries we like and, within those countries, make individual decisions as to whether we prefer exposure to hard or local currency debt. By virtue of implementing multiple investment decisions, we can even be ‘early’ or just wrong in respect of a few positions and yet still generate positive returns in aggregate.

Pronounced divergence between hard and local currency returns

Source: GAM and JP Morgan. Period analysed 31.12.2011 to 30.06.2014

Past performance is not an indicator of future performance and current or future trends.


The table above shows how a period of identical performance for the hard and local currency indices can mask huge divergences at the country level where, for example, Indonesian hard currency returns exceeded those of local by around 30 percentage points, while South Korean local currency bonds outperformed their hard counterparts by a similar extent.

While this is obviously a particularly stark example, the concept of large return discrepancies on a country level is clearly evident every single calendar year since inception of the two indices. For example, Colombia has been the best performing local currency market year-to-date, and within just a few months a material divergence of around 15% between hard and local currency debt has already been established.

As such, it is supportive of our country approach where we can harness more opportunities which extend further into the dynamics of the underlying markets. For example, during 2017 we transitioned our exposure from nominal local bonds in Brazil to inflation linkers, which contributed additional alpha to a ‘winning’ position.

You can see this disparity over a longer period in the chart below.

Difference in percentage points between hard and local currency

Source: GAM and JP Morgan

Past performance is not an indicator of future performance and current or future trends.


Basic balance

Looking ahead we remain positive on EMs. We believe that ‘basic balance’ (current account + foreign direct investment as a percentage of GDP) provides the best guide to the resilience of EM. When the basic balance is negative, the universe is very sensitive to shifts in investor sentiment and flows may turn negative. This proved the case in 1994 and 2011/12. Conversely, when the basic balance turns positive (which it did towards the end of 2015), this can herald an extended period of outperformance, such as that witnessed from the 2001/02 period onwards.

Consequently, we believe the worst of the balance readjustment is behind us, something we have been highlighting for more than two years, and that the positive cyclical environment for EM could endure for a further three or four years. While it remains the case that unexpected Fed tightening has the capacity to upset markets, it is important to look at this in the context of a positive balance which renders EMs well positioned to withstand periods of volatility. In addition, valuations are not stretched in either absolute or relative terms and we are also seeing positive and accelerating EM growth momentum versus the G4/G10 complex.

We are therefore constructive on the outlook for EMs in the period ahead and will continue to seek to exploit the performance divergences that arise as a by-product of the heterogeneous nature of the EM universe.


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Source: GAM unless otherwise stated.

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The views expressed herein are those of the manager at the time and are subject to change. Past performance is not indicative of future performance.

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In the United Kingdom, this material has been issued and approved by GAM London Ltd, 20, King Street, London SW1Y 6QY, authorised and regulated by the Financial Conduct Authority. April 2018