Growth prospects might appear to be challenging for developing economies across Asia amid China’s economic slump, higher-for-longer interest rates globally and increased geopolitical tensions.
However, for those seeking portfolio diversification with potential upside, emerging market debt (EMD) currently offers opportunities.
One of the attractive features of investing in EMD – in addition to low correlation with other asset classes, like today’s high-flying and higher-risk equities – is the ability to invest across segments that often react differently to various macroeconomic environments. This allows managers to allocate capital against the most appropriate benchmark.
However, there is no single best-performing sector in EMs. With this in mind, active investors should have as much flexibility as possible to create a blended portfolio.
So, what should an EM blended portfolio look like? Capital should be allocated to take advantage of the three distinct return streams within EMs: hard currency sovereign and corporate debt, local interest rates and currencies.
In order to construct the most robust portfolio, an understanding of how each of these segments have performed over time, and how an investor would benefit from allocating to each position as the economic climate waxes and wanes, is a crucial first step.
Hard currency sovereign and quasi-sovereign debt – bonds issued by countries or state-owned enterprises, mostly in US dollars – generally do well in ‘risk on’ markets and stable higher-rate environments. This is also a sector diversified enough to allow select performance in more volatile markets. Taking this into consideration, this is an area we are constructive on against the current backdrop of moderating growth and inflation.
The current carry (meaning the additional compensation an investor can expect above the 10-year US treasury) offered in hard currency is attractive. Sovereign yields are near 8%, providing a cushion for any near-term spread volatility or potential rise in US treasury yields. And in the event of additional spread tightening or treasury yield compression, returns could be pushed to double digits.
Hard currency corporates historically have noteworthy characteristics, especially during a time where global growth is uncertain. These are generally shorter-duration bonds that tend to outperform in volatile markets. A selective approach to these bonds can offer idiosyncratic opportunities with attractive relative value in high-growth economies. And if global growth declines, holding bonds from strongly rated EM companies can outperform in a volatile and risk-off market.
In slowing global growth markets, hedged EM local rates can perform well, offering attractive real yields with steep curves as interest rates are taken down to boost growth.
In this dynamic, a slower global market would normally strengthen the US dollar and hurt EM trade volume. However, local market performance may be challenged unless the Fed begins cutting rates soon and EM inflation data improves materially.
Nonetheless, over the medium term, the carry and rolldown (the capital gain created by the fall in yields as the bond approached maturity) offset the negative impact of EM foreign exchange.
The differential in growth between developed market economies and EM economies has a strong influence on EM foreign exchange (EMFX) trading. Inflation is falling faster in EMs than developed markets, and EM growth should benefit as central banks begin to cut rates. As some countries race ahead and others fall behind, relative value opportunities emerge.
To achieve proper portfolio construction, identifying the difference between strategic and tactical allocations is critical. The long-term strategic cornerstone of a portfolio should lie in hard currencies, as the returns here are the result of a country’s fundamental trajectory coupled with current valuations.
Complementing this approach, local market allocation should be viewed as tactical, as this tends to be more cyclical.
Today’s market provides a great example of this strategic/tactical approach. While we believe there will be value in EMFX over the next few years, we have more confidence in spreads than in EMFX over the long term. This does provide tactical opportunities in EMFX, but they should not construct the core of an EM portfolio.
Investors should avoid the temptation of investing broadly across EM sectors from a ‘top-down’ perspective. While using a simplified top-down allocation or static allocations among sectors may be intuitively appealing, it will lead to a suboptimal allocation of assets. A portfolio will produce stronger returns by actively allocating to the highest-returning opportunities rather than focusing on a specific sector.
Cathy Hepworth is head of PGIM Fixed Income’s emerging markets debt team
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