Waddell & Reed

Portfolio Perspectives

Are opportunities coming in emerging market debt?

Story Highlights

  • Volatility has the potential to create opportunity.
  • The market may have addressed Fed policy concerns.
  • Competitiveness challenges may be key for some EM countries.
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Investment Team

Simon Lue-Fong

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.

Investment return and principal value will fluctuate, and it is possible to lose money by investing.

Risk factors. An International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may seek to manage exposure to various foreign currencies, which may involve additional risks. The value of securities, as measured in U.S. dollars, may be unfavorably affected by changes in foreign currency exchange rates or exchange control regulations. Investing in foreign securities involves a number of risks that may not be associated with the U.S. markets and that could affect the Fund’s performance unfavorably, such as greater price volatility; comparatively weak supervision and regulation of securities exchanges, fluctuation in foreign currency exchange rates and related conversion costs, adverse foreign tax consequences, or different and/or less stringent financial reporting standards. Sovereign debt instruments are also subject to the risk that a government or agency issuing the debt may be unable to pay interest and/or principal due to cash flow problems, insufficient foreign currency reserves or political concerns. Risks of credit-linked notes include those risks associated with the underlying reference obligation, including but not limited to market risk, interest rate risk, credit risk, default risk and foreign currency risk. The buyer of a credit-linked note assumes the risk of default by the issuer and the underlying reference asset or entity. If the underlying investment defaults, the payments and principal received by the Fund will be reduced or eliminated. Also, in the event the issuer defaults or there is a credit event that relates to the reference asset, the recovery rate generally is less than the Fund’s initial investment, and the Fund may lose money. The use of derivatives presents several risks including the risk that fluctuation in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Moreover, some derivatives are more sensitive to interest rate changes and market fluctuations than others, and the risk of loss may be greater than if the derivative technique(s) had not been used. Derivatives also may be subject to counterparty risk, which includes the risk that a loss may be sustained by the Fund as a result of the insolvency or bankruptcy of, or other non-compliance by, another party to the transaction. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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