Emerging market debt investors should pay attention to history, but not expect a re-run of the late-1990s. Anthony Gillham of the Old Mutual Voyager Strategic Bond fund explains.
We all know emerging market debt had a pretty torrid 2013. But to understand just how turbulent it was, a sterling investor would have to look all the way back to 1997-98 to find something that comes close to the experience. Sterling’s strength last year did nothing to help unhedged investor returns but, really, that is splitting hairs – 2013 hurt.
The good news is that history teaches us that big setbacks to risky assets tend to overshoot. For example, in 1998, a sterling investor in emerging market sovereign credit would have suffered similar losses to this past year of just under 10% and been much worse off in 1994. However, in the years following these outsized negative returns, we saw the asset class stage a convincing comeback (see graph).
Another Asian crisis?
Clearly, it would be foolish to hold this out as a sure thing. However, as Mark Twain observed: “History doesn’t repeat itself, but it does rhyme.” At the end of the 1990s, the tone for emerging market performance had been set by the Asian financial crisis, in large part triggered by big externally financed current account deficits.
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Put simply, foreign investors financed emerging market deficits in their search for yield in a world of comparatively higher foreign interest rates. Sound familiar? By the same token, could it be that what we are dealing with today, as back then, is a cut-and-dried emerging markets balance of payments crisis?
As it happens, there are a number of reasons why such a comparison does not hold: most important, debt levels look much healthier in the emerging world today, at just 26% of GDP on average (J.P. Morgan, 2014). This underscores the fact we do not face a balance sheet problem.
Furthermore, we have not seen anything like the level of international involvement that we saw in 1997-98. The legacy of the International Monetary Fund’s (IMF) intervention in Asia has been institutional and behavioural reform that we have seen replicated across emerging markets, which have built high foreign currency reserves.
Meanwhile, the monetary institutions we recognise in the West now exist in the emerging market world too – the most important being inflation-targeting central banks.
There are two important consequences of this. The first is that current account deficits are, for now at least, self-financing. A high savings rate throughout the 2000s built a margin of safety in national accounts. The second is that the presence of monetary institutions means that, instead of crises, we have seen mature responses to external pressures.
Away from Asia, Brazil provides an excellent case in point. Running a current account deficit of -3.6% GDP in 2013 (J.P. Morgan, 2014), we saw the real depreciate by 13%, placing significant upward pressure on inflation. But the Brazilians are putting their own house in order.
Memories of hyperinflation run deep and, today, the Brazilian central bank is affirming its inflation-fighting credentials, as the COPOM has hiked the SELIC rate by 3.25% since the start of 2013.
This problem lies in stark contrast to that in the developed world where, as head of the IMF Christine Lagarde recently noted, “deflation is the ogre that must be fought decisively” and which has driven central banks in the US, UK and Japan to pursue an untested monetary response.
Recognising the chronic nature of a debt deleveraging cycle, the central banks that have pursued quantitative easing have sought to distort bond markets, artificially depressing bond yields and generating negative real interest rates, which many investors seem so prepared to accept.
In spite of this, in the eurozone, we see evidence of complacency. Last year was fantastic for eurozone risk assets but the currency union countries still face significant economic and political challenges in 2014.
That the near collapse of the Portuguese government, German elections and the downfall of Italy’s Silvio Berlusconi did not produce so much as a blip in markets is surprising.
This year, Europe faces a much graver test of fundamentals: the Asset Quality Review. Should it turn up a surprise somewhere in the banking system, there would no longer be any margin of safety in asset prices.
The issue of margin of safety is hardly new and has formed the basis of many celebrated investment approaches: Graham, Dodd and Buffet to name but three. Central to these is that investors run higher risks when they follow the herd because there is no room to manoeuvre if something changes.
Investors who tactically buy the dips, with a margin of safety, stand a much better chance than those who permanently impair their capital by locking in losses.
As the yield on local currency emerging market bonds approaches 7%, it is clear to me where we should be looking to find this margin of safety in 2014.
EMD’s ‘convincing comebacks’ (31 Dec 1993 to 31 Dec 2013)
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