Looking at EMD asset classes: where are the opportunities?
A week ago we shared our outlook for EMD in general for 2018. In this publication our experts provide their expectations for different asset classes within the EMD universe.
Emerging market (EM) fundamentals started improving in 2016 and have accelerated over the last year, with growth broadening across regions and countries. NN Investment Partners (NN IP) believes that 2018 will be another positive year for EM Debt (EMD) and that the improved fundamental picture will allow risk premiums to compress further, with total returns ranging between 4% and 8%.
NN IP’s constructive view on EMD is largely based on improving fundamentals and the attractiveness of the asset class relative to other fixed income markets. In particular, robust global growth and strong EM fundamentals should boost EMD performance, China is seen as less of a risk and more as a key driver of EMD performance while neither politics nor monetary policy globally are likely to prove decisively negative.
NN IP’s Emerging Market Debt specialists give their views on different asset classes within EMD and highlight the opportunities they identify.
EMD Hard Currency
Within the hard currency category, NN IP has a strong preference for Frontier Market Debt. Marcelo Assalin, Head of Emerging Market Debt at NN IP, says this is because frontier markets are at the very beginning of their development with higher potential economic growth and favourable demographics. They also constitute the higher-yielding part of the HC universe yet entail lower risk because of the relatively low duration of their bonds combined with a low correlation to US treasuries and the potential for their currencies to appreciate.
Emerging market sovereign bonds denominated in hard currency are still highly attractive relative to other fixedincome asset classes, even though spreads are tight, because positive risk sentiment is still spurring inward capital flows, says Marco Ruijer, Lead Portfolio Manager, Emerging Market Debt Hard Currency at NN IP.
Ruijer commented: “The EM hard currency market was characterized by a lack of volatility in 2017. There was not a single correction, only small downward movements in spreads. The low volatility was largely the result of the record high inflows. Given that global growth and EM fundamentals are improving and commodity prices are stable, we believe that inflows will continue and spreads can tighten further over the course of the year, which will be somewhat offset by a rise in US Treasury yields.”
EMD Local Currency
EMD denominated in local currencies (LC) are likely to see strong performance in 2018, NN IP believes. Lewis Jones, Senior Portfolio Manager, Emerging Market Debt Local Currency at NN IP, says this is due to co-ordinated broad-based global growth, a solid fundamental backdrop and investor appetite for high yielding and relatively cheap assets assets, which should drive capital inflows and lead to appreciating EM currencies.
Jones commented: “In contrast to 2017, when bonds delivered relatively stronger performance, this year we expect currency and high real interest rates to drive the bulk of our forecasted high single-digit total return for the EM local bond index, with bonds delivering a flat to marginally positive performance. EM local currency debt finished 2017 up 15.2%, 5.8% of which reflects FX gains versus the US dollar, with the remainder being a combination of carry and capital gains on bonds.”
Emerging Markets Corporate Debt
Within the EM Corporate Debt sector, the most interesting region for investors is undoubtedly Latin America, which has the highest yields and the best potential for further spread compression, says Joep Huntjens, Head of Asian Fixed Income at NN IP.
Huntjens explained: “LatAm also has the largest delta in terms of fundamental improvement potential and it benefits relatively more from rising commodity prices. It is important to monitor political risk this year as the region will be marked by elections in several key countries. But we see enough reasons to hold on to an overweight position in Latin America.”
He added: “Overall, we foresee a continuation of the benign conditions for the EM corporate debt market. In an environment of strong global growth, access to capital markets, and supportive commodity prices, a meaningful rise in corporate defaults is unlikely.”
Asian Debt Hard Currency
Although Asian hard currency debt often represents a very small part of investors’ portfolios, it is fast becoming a mainstream asset class, says Joep Huntjens. Sentiment towards it has improved after concerns about a hard landing of the Chinese economy have eased considerably and NN IP anticipates a total return for the asset class of 4% to 5% in 2018.
Huntjens commented: “Asian debt had another strong year in terms of performance. The JACI index, the benchmark of our Asian hard currency debt strategy, showed a total return of 5.8% in USD terms, helped by the impressive performances of the frontier market exposure and Indonesian sovereign bonds in particular.
“Chinese GDP growth surprised on the upside in 2017 thanks to the improvement in global growth but the deleveraging trend will cause growth to slow down. However, the quality of growth is improving.
“Our performance expectations for the asset class are based on a modest increase in US Treasury rates, which will mainly be offset by tighter spreads. Valuations seem tight, both on a historical basis and relative to other EM regions. However, compared to equally rated bonds in developed markets, spreads in Asia are higher and duration is typically lower at five years.”
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