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The Philosophy of EM Bonds

26 November 2019

Developed markets are the driver behind emerging markets, says GAM Investments’ Paul McNamara. He discusses his investment philosophy and identifies some country-specific opportunities.

Emerging markets have the twin advantage and disadvantage of being high risk investments. Today, eight out of 10 top emerging markets are investment grade (IG)1, compared to only four going back 15 years. Our approach is to seek to capitalise on the volatile nature of these evolving landscapes. Our investment philosophy, put simply, has the goal of identifying what could be viewed as the ‘junk’ markets that will eventually grow into true economic contenders. In a way, we are seeking to add value by disagreeing with the market and being right. We constantly ask ourselves, “What would make us change our minds about this market?” and apply this across a macro, theme and micro level.

Crucially, we believe developed markets drive emerging markets. This has resulted in several top-down themes for country selection, which we can use to establish baseline scenarios for the ‘big three’: the US, Europe and China. By assessing the impact of global influences and domestic market forces on emerging markets, we are able to set risk and return expectations for local debt bond markets.

On the subject of the US, we believe that a recession is unlikely. US new borrowing is still at modest levels, although growth may well slow as fiscal stimulus fades. Meanwhile the euro area had a weak second quarter, but fundamentals remain sound. The European Central Bank (ECB) lending survey suggests the credit impulse should remain positive. In China, we expect activity to strengthen in Q3, although growth could still be derailed by the trade war.

Chart 1 - US new borrowing is still at modest levels


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

Source: Haver Analytics and BEA as at 30 Sep 2019.

Chart 2 - US credit impulse and spending growth


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

Source: Haver Analytics and BEA as at 30 Sep 2019.

Country-specific information can then be combined with market data to highlight the anticipated winners and losers, guiding the development of our investable ideas and assisting with our ongoing market monitoring. We use this information to flag markets when they appear to be recovering from a crisis. For example, Turkey appears to be on the brink of improvement, whereas Argentina is still struggling following its recent electoral upset. Unlike Turkey, Argentina’s problem is one of solvency, not liquidity, and this usually takes longer to resolve.

When making these decisions, we rely chiefly on nine indicators of an emerging market’s status – from overall competitiveness to environmental, social and governance (ESG) factors to currency liquidity. We take the view that any country that scores five negatives is a country we do not want to be invested in. Red flags that we look for include a rapid decline in reserves, popular appetite to hold US dollars or euros instead of local currency, a large external deficit and a seriously overvalued currency.

Further to this, we have found that the three key drivers to emerging market dynamics are global environment, credit cycle and policy. These drivers interact and change over time.

In particular, we emphasise the role of credit in the economic cycle. We feel that most of the information not reflected in asset prices is contained in credit-related macro events, across both developed and emerging markets. We also take long-term solvency trends in the public and private sectors into account.


Chart 3 - The crisis filter helps identify economic turning points


Philosophy of EM bonds Chart 3

Source: GAM; for illustrative purposes only

It is our opinion that the majority of what happens in local emerging bond markets is explained by global variables and tensions. When compared to the developed world, the emerging world has a long history of populism and protests, often linked to the country’s economic plight. Investor bias tends to contribute to the subsequent dismissal of emerging markets in the light of such protests. We believe that political unrest does not constitute a reason to ignore investing in a country any more than the Gilets Jaunes protests are a reason to avoid investing in France. Political turbulence may indicate future volatility, but risk has to be assessed along with price to decide whether an investment is good value.

Aside from the previously mentioned Turkey and Argentina, we can find additional examples in Brazil, where credit growth has stabilised and the credit impulse has turned negative; Mexico, where growth is held down by sustained weakness in construction and energy; Colombia, where credit growth is now low and stable; and India, where the main risk is the balance of payments. The crisis cycle filter analyses the common risks associated with emerging markets and determines when a rebound might be possible. Our goal is to capitalise not on crisis, but on crisis recovery.

1China, South Korea, Taiwan, India, Russia, Mexico, Malaysia and Thailand

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.