Outlook - Funds People

For professional investors and advisers only
November 2013
Schroders
Outlook
2014: Emerging Markets Debt Relative
James Barrineau, Co-head Emerging Markets Debt Relative
Emerging market debt will finish the year in negative territory,
a victim of US Treasury volatility spurred by potential changes
in Federal Reserve (Fed) policy. The most liquid parts of the
asset class – sovereign dollar bonds – have fared the worst
given their correlation to treasuries. Fear of the impact of
less loose monetary policy has soured investors on the asset
class, and fund outflows have been steady since the middle
of the year.
–Investors can no longer rely on
ratings upgrades and falling Treasury
yields to drive emerging market debt
performance
–Emerging market debt exposure
through a manager benchmarked
to the primary indices is likely to
leave an investor with both emerging
market-specific volatility coupled with
significant US Treasury rate risk
–We think exposure to the widest
possible opportunity set in emerging
markets is the best way to avoid this
risk, and gives the highest probability
of achieving attractive absolute returns.
“Local currency rates are
probably the most attractive
part of the opportunity set.”
Looking ahead into 2014, investors should abandon their reliance on the traditional drivers
for outsized emerging market debt returns – steady credit ratings upgrades and a strong
US Treasury tailwind – and focus instead on significant pockets of value that offer better
potential returns than many alternative asset classes.
What just happened?
Until the end of April the EMBIG index was down only 0.4% for the year. Then came the
Fed’s tapering warnings, which led to a nearly 9% drop in the two subsequent months.
While the popular press began to talk of an “EM crisis” what in fact was occurring was a repricing of all emerging market debt assets in conjunction with an ongoing normalisation of
the US interest rate structure. The key point is that crises do not occur when countries and
companies continue to have access to debt markets, meaning that default risks remain low
as existing debt is re-financed even at slightly higher rates. That process continued even in
the depths of the asset price declines, as well as beyond. Currency levels have also greatly
depreciated across the asset class, with the exception of Eastern Europe. While this has
meant a difficult time for those investors with local currency exposure, the weaker currencies
have already begun to adjust external imbalances and should continue to do so next year.
Fundamental damage contained
In a world of slower economic growth in general, credit rating upgrades across major
parts of emerging markets are unlikely. That does not mean that a steady deterioration in
fundamentals from here is inevitable, however. Through the third quarter of 2013, growth
for all emerging markets was about 2% higher than that of developed markets, a margin
that should hold steady. Most emerging market countries accumulated significant foreign
exchange reserves through the good times of the previous decade, and most fiscal
accounts are in primary surplus. Current account deficit countries are at most fundamental
risk, but the required adjustments of slower economic growth and weaker currencies to
close those deficits have already begun to varying degrees.
Outlook 2014: Emerging Markets Debt Relative
A new game-plan for EMD investing required
Next year should see a continuation of the re-pricing that has occurred, assuming 10-year
US Treasuries settle in a 3.25 – 3.5% range, which would be a normal level of real interest
rates historically. Investors often believe that emerging market debt exposure provides
them with a more volatile asset class that reacts differently than their other fixed income
investments. 2013 amply demonstrated this is no longer true. About 75% of the EMBIG
index, and two-thirds of the corporate index, are investment-grade bonds that trade with
high correlations to US Treasuries. Therefore, allocating emerging market debt exposure
to a manager benchmarked to the primary indices is likely to leave an investor with both
emerging market-specific volatility coupled with significant US Treasury rate risk.
James Barrineau
Co-Head of Emerging
Markets Debt Relative
James Barrineau joined Schroders in
April 2012 as Co-Head of Emerging
Market Debt Relative. Prior to
joining Schroders, he worked as a
Senior Portfolio Manager-Sovereign
from 2010 to 2012 at ICE Canyon,
an alternative investment firm
specialising in emerging market debt.
Jim worked as an emerging market
debt and currency strategist for
Alliance Bernstein from 1998 to
2010, with primary responsibility for
Latin America. From 1996 to 1998,
Jim was the Latin American equity
strategist at Salomon Smith Barney,
and from 1994 to 1996 he was the
emerging market debt strategist at
the same firm. From 1988 to 1994,
he was a senior economist for the
US government.
We think exposure to the widest possible opportunity set in emerging markets is the best
way to avoid this risk, and gives the highest probability of achieving attractive absolute
returns. Emerging market corporate debt should continue to be the lowest volatility part of
the asset class as cross-over investors from the high yield universe gain exposure to bonds
that out-yield their index by well over 100 basis points. A diversified basket of corporate
bonds with maturities of seven years or less can be constructed that offers much higher
yields than other fixed income alternatives, while avoiding interest rate risk.
Sovereign debt is likely to underperform, assuming US Treasuries continue to adjust.
Spreads to Treasuries are now about average compared to historical levels, and do not
offer a margin of safety sufficient to compensate for risks, in our view. Some non-investment
grade countries will offer substantial value for short duration debt as long as market access
is available. Local currency investing will remain volatile, in our view. We think a mix of
currency funding sources, including periodically shorting current-account deficit countries,
can mitigate volatility substantially. Local currency rates are probably the most attractive part
of the opportunity set and stable markets would likely see substantial rates compression in
markets that have sold off simply on the back of US Treasury moves.
“A diversified basket of
corporate bonds with
maturities of seven years
or less can be constructed
that offers much higher
yields than other fixed
income alternatives, while
avoiding interest rate risk.”
Important information: The views and opinions contained herein are those of James Barrineau, and may not necessarily represent views expressed or reflected
in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in
any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not
be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness
or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual
investment and/or strategic decisions. Issued in November 2013 by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and
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