Are opportunities coming in emerging market debt?
- Volatility has the potential to create opportunity.
- The market may have addressed Fed policy concerns.
- Competitiveness challenges may be key for some EM countries.
Portfolio Manager, Pictet Asset Management (subadvisor)
The investor appetite for emerging markets has been somewhat fickle. Depending on the day’s headlines, investors have vacillated between embracing the potential and fleeing the possible risk. No matter the view, the emerging market story is one that will likely continue: This year, emerging markets are expected to chart economic growth of 5%, according to an April projection from the International Monetary Fund. Comparatively, the IMF projects advanced economies to grow around 2.25% over the same period.
Simon Lue-Fong, portfolio manager of the Ivy Emerging Markets Local Currency Debt Fund, takes a look at emerging markets and emerging market debt.
Emerging markets have been particularly volatile over the past several months, but volatility can also create opportunity. What is your view on the recent environment?
We really like it when emerging markets are volatile, because they are a risk premia asset class. Let’s consider, for example, a country like the Philippines. Most people think that the U.S. dollar is quite safe and U.S. Treasuries are quite safe, but they probably are not really sure about the Philippines, so you have to get paid a little bit more to take that risk. Risk premia increases when you have volatility, and that provides opportunity. What we’ve seen over the past eight months or so has been a good thing for emerging market investors, because that higher risk premia potentially results in higher returns.
Concern about rising interest rates in the U.S. introduced a wave of uncertainty for emerging market investors. What are your views on how a Federal Reserve (Fed) policy shift toward a rising rate environment might impact emerging markets?
People said that emerging markets were a beneficiary of the Fed’s asset purchases under quantitative easing (QE) and therefore as soon as QE was over, emerging markets would do badly. That fear was definitely present last year. But we have had several taperings of the Fed’s asset purchases, and I think that the tapering fears have been quieted by the market. As far as rate hikes, I think the subdued growth in the U.S. in the first quarter may have slowed any Fed progression toward higher rates. Overall, it’s still unclear how a rate hike would impact emerging market debt, but based on what we’ve seen with tapering, I think the market could be comfortable with a modest increase in U.S. front-end rates.
What is your outlook for emerging markets?
The subdued economic data in the first quarter has created the potential for some short-term vulnerability, but I think the same could be said for other areas of the market as well. Beyond that, we remain positive. We believe the fundamentals are strengthening and we are seeing a gradual improvement in economic data. If the global economy is recovering, and we think it is, then we believe that emerging markets will strengthen as well. However, these economies may also see continued pressure as the developed economies transition toward a period of what might be considered a more normal interest rate environment. That said, depending on how events play out, it may create additional opportunities in emerging countries with political and economic stability, such as Mexico and the Philippines.
Where do you see the potential risks?
One of the challenges for emerging markets broadly will be how they address potential changes to their competitiveness in the export market where slipping productivity and rising labor costs would not be beneficial. That said, it is important to recognize that each emerging market country is different and has its own economy and its own economic drivers. That is also reflected in interest rates that, in some cases, they appear to almost be polar opposites. For example, Brazil’s central bank pushed that country’s key interest rate to 11% in April while Mexico’s central bank has that country’s key rate at 3% after a rate cut of 0.50% in early June, which is a record low. That range illustrates one of the reasons why we prefer local currency emerging market debt over emerging market debt issued in U.S. dollars, which, by its nature, has the potential to be more significantly influenced by what is going on with the U.S. economy, the U.S. interest rate environment and the dollar. As far as other things that may be a risk, at least to the global economic recovery, a number of them are already well-known by the market, such as the situation with Russia and Ukraine, and the apparent slowing growth in China. And, of course, there is the risk of an unexpected event that could impact investor sentiment. For emerging market debt, all of this relates back to the earlier question about volatility and the potential risk premia that may be created within the sector. We are always keeping a close eye on valuations so we can capture what we think are the best opportunities.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 17, 2014, and are subject to change due to market conditions or other factors.
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