Positive prospects for emerging market debt in 2012

We continue to have a favourable outlook on emerging markets and emerging market debt in particular for 2012. Our preferred way of looking at emerging markets is by thinking of them as “assets tied to economies of risky countries” (ASTERISCS). In most cases, the country risks - the characteristic distinguishing emerging markets from other asset classes - reflect the reasons why the vast majority of emerging market countries are not yet rich. So when we say we like emerging markets, we mean, in practical terms, that we like assets tied to economies of non-rich countries - countries whose gross national income, GNI, per capita falls below the upper quartile, as estimated by the World Bank.

Promise of higher growth rates

What is the continuing appeal of non-rich countries? First, their economies carry the promise of growth at higher rates. This makes intuitive sense as non-rich countries are starting at a lower base. In addition, structural reforms, widespread improvements in creditworthiness, and more prudent macroeconomic policies in many (though not all) cases have created favourable conditions for the potential outperformance of emerging market economies. In 2012, in particular, we agree with the consensus view that emerging market economies will likely expand faster than those of developed countries, in line with the trend observed over the past decade. While we always treat consensus views with healthy scepticism, we find no reason to disagree with this one.

Second, non-rich countries have managed to avoid debt excesses currently plaguing the developed economies. With sovereign balance sheets of developed, rich countries burdened by the costs of rescuing their private sectors, the balance sheets of non-rich countries compare favourably. While non-rich countries definitely have challenges of their own, they do look better than many of their developed counterparts.

Third, investors in the developed world are actively searching for ways to diversify their portfolios to mitigate a pronounced home bias (i.e., an investment concentration in domestic assets). We believe a careful, selective exposure to the assets of non-rich countries can be a prudent choice to increase international diversification. We also think it is important to emphasise that country diversification does not necessarily protect investors against sharp global crises. Unfortunately, there is little evidence in our view to dispute the old adage that “diversification works least when you need it most.” However, over long periods, we believe globally diversified portfolios can meaningfully outperform portfolios with a home bias.

In our opinion, asset classes of non-rich countries are not decoupled from the asset classes of their rich counterparts. The global market falls in September 2008 were a reminder of that, just as the market challenges in September 2011 were. As such, we believe the biggest potential threat to emerging markets in 2012 would be an unexpected slowdown in global economic activity. The slowdown could result from an escalation of the sovereign debt problems in the developed world or it might occur if the economy of a major non-rich country such as China would begin to sputter. While we do not expect a global double-dip recession, we are mindful of this risk and monitor it closely.

Positive growth and currency appreciation

Investing in emerging market fixed income in 2012 will continue to provide investors with two distinct options to capitalise on the expected positive growth differentials between rich and non-rich countries: US dollar-denominated and local currency bonds. Spreads of US dollar-denominated emerging market bonds are generally correlated with spreads of similarly rated corporate bonds in the US. Still, an exposure to US dollar-denominated bonds offers investors valuable issuer and country diversification.

In our view, local currency emerging market debt is poised to continue to attract investor interest in 2012 as well. The reason for this burgeoning interest is not just the potential for high single-digit/low double-digit returns, based on a yield of 6-7%¹, but also the potential for local currency spot rate appreciation against the currencies of developed countries, the US dollar in particular. Just as important is the fact that the types of risks to which local currency bonds are exposing their foreign investors - emerging market currency and local duration - are distinct from the types of risks (e.g., spread, equity) that these investors already have in their portfolios. Local currency bonds issued by emerging market sovereigns are a relatively liquid asset class. As a result, its performance is affected by developments in other liquid asset classes in emerging markets and elsewhere. However, over longer periods of time, the distinct nature of risks associated with local bonds creates sizeable gaps between their performance and that of other asset classes. This is why we think local currency bonds can be an attractive addition to a well-diversified portfolio for 2012 and beyond.

1. Based on the JP Morgan GBI-EM Global Diversified Index as of November, 2011. The index is a global local emerging markets index, consisting of regularly traded, liquid, fixed rate, domestic currency government bonds