Multi Asset Boutique

How to harness the headwind: seeking profit from emerging-market assets

Emerging Markets

After a perfect pandemic storm, the US Federal Reserve and other supersized container ships are picking up unusual cargo. Corporate paper? Put them in the hold. Bond ETFs? Shovels full. Junk bonds? Use the crane. This may seem like the age of indiscriminate buying – hardly a strategy many investors find alluring. We hope to direct their gaze towards often-shunned merchandise that nevertheless may hold great promise. In our opinion, equities and hard-currency bonds shine in the eye of the discerning active investor.

Emerging markets in particular have been buffeted by the crisis. The coronavirus has sparked a heavy sell-off – not as severe as the one during the global financial crisis in 2007/08, but nearly as bad as the worst three drawdowns in recent memory (see chart 1). Yet it is also true that since March until August, emerging-market equities and bonds have snapped back like a storm-bent palm tree. Investors, previously blown to the four corners of the earth, have noticed. According to a recent Vontobel survey,1 two-thirds of the respondents plan to increase their exposure to emerging-market equities, and 59% plan to raise their holdings in emerging-market bonds.


The fundamentals have improved

In theory, one could have expected emerging economies to perform better. By the end of 2019, many emerging economies exhibited much greater resilience (e.g. solid current accounts) than in 2007/08 and during the so-called taper tantrum phase in 2013 (see chart 2). While sovereign debt has risen, lower refinancing costs in many countries have partly compensated for the higher debt load. Moreover, since the end of 2019, the world economy and emerging markets entered a cyclical recovery with only moderate inflation pressure. Usually, this is an environment in which emerging-market assets, in particular growth-sensitive ones like local-currency debt and equities, outperform.


Solid fundamentals notwithstanding, emerging market prospects largely depend on “push factors” – developments beyond the countries’ control. Among the negative effects of the pandemic were the breakdown of supply chains and a global demand shock that hit the industrial and services sectors in emerging markets particularly hard. Add to that collapsing commodity prices, rising corporate default risks, and a temporary drying up of US dollar liquidity – a particularly worrying event for emerging economies, which rely on US dollar-denominated bond issues next to local-currency debt. Fortunately, the coastguard sprang into action. Setting an example of American leadership, the US Fed threw emerging-market castaways a lifeline via a sizable US dollar swap facility to ease the dollar illiquidity. Additional government programs to support the economy helped as well.

Not too late to hop on the long-term return train

With emerging markets already recovered from this spring’s losses, some observers may wonder whether they have missed an opportunity. This brings us to our analysis of long-term return potential estimates based on seven-year cycles, which should reduce timing risks. Our long-term return estimates (see chart 3) reveal that emerging-market equities and hard-currency bonds look very attractive in a portfolio context.


A favorable view on emerging hard-currency debt rests on the assumption that the significant decline of yields in the corporate investment-grade and government bond sectors leaves global investors with few alternatives beyond high-yield paper and emerging-market hard currency bonds. After a spike to 8% in late March 2020, the yield on hard-currency debt (known as EMBI) came back to 5% during the summer months, which is still superior to yield levels seen in most other bond segments. Generally, the trend towards higher inflation in emerging markets – which reduces purchasing power over time and depresses the long-term return potential – is incorporated in our estimates.

Local-currency bonds attractive if well-timed

While the potential of local-currency emerging-market debt seems limited with estimated long-term returns broadly matching those of investment-grade corporate bonds (depending on the investor’s currency), the merits of engaging in this sub-segment can be considerable. Here, investors should take a tactical, i.e. opportunistic, approach given this asset class’s dependence on external factors like moves in commodity prices and the US dollar. This could mean holding local-currency paper with the view of rapidly increasing or decreasing it depending on external market developments. Should the dollar weaken – as we expect over the next 12 months – emerging-market currencies have moderate recovery potential. Naturally, the outcome of the US presidential elections or new twists in the US-Chinese trade saga could change currency forecasts overnight.

Asia favored in equity portfolios

Navigating the bond subsectors and a multitude of above or below-zero yields can be a challenge. By contrast, it seems much harder to spot any negatives in equity markets given the return potential highlighted in chart 3. Here, emerging-market stocks outshine developed-market ones by a wide margin, according to our return potential estimates. The valuation approach focuses on the equity risk premium, price-to-book and price-to-earnings ratios, with especially the latter two signaling an attractive return potential over time. Not surprisingly, investors looking to invest in emerging-market equities look set to continue to favor Asia – a region that appears most resilient in our analysis – and particularly China due to the technology-heavy corporate landscape there. Digital companies’ strong business during the pandemic is a case in point.

Risks seem overstated – look at the differences

Some investors, haunted by the specter of country defaults, shy away from emerging-market equities or bonds. We agree that defaults are probably on the rise. Unfortunately, they are likely to affect the poorest developing countries that derive 70% or more of their revenues from tourism. Therefore, countries in the Caribbean may be hit hard. However, for the majority of countries within the benchmarks we analyzed in chart 1, default risks are overstated, in our opinion. Already in 2009, Carmen Reinhart and Kenneth Rogoff2  not only highlighted the decline in the number of defaults (see chart 4), but also concluded that the link between the level of debt and sovereign debt defaults is weaker than many observers believed. Debt servicing indicators – which have improved due to the global low-yield environment – matter more than the level of debt. The two US economists also showed that countries with a track record of defaulting are more likely to default in the future. However, they coined the expression “graduation” as well, which means that countries can overcome their track record by proving they can repay their debt over a long period of time.

Help from Jackson Hole

The paucity of defaults in recent years raises hopes that the “graduation trend” will continue. Generally, we believe Asian economies are among the best-placed in the emerging-market space to manage external shocks. It is also worth noting that, in our view, some countries like Mexico and Russia, both of which possess sound fundamentals, were overly penalized during this year’s market downturn.


Moreover, as long as major central banks keep interest rates low – and the recent smoke signals from the central bankers’ powwow in Jackson Hole indicate this will remain the case – debt sustainability risks are rather moderate. A conclusion we drew as well in our recent white paper “modern monetary theory”.3

Don’t sail with the crowd

Being an investor hasn’t become easier. While this spring’s panic selling is almost forgotten, the coronavirus continues to haunt us. The challenge is to look past the headlines towards attractive market sectors, a task that can be best accomplished through active portfolio management, we believe. Keeping track of the different fundamentals of emerging economies, and specific developments such as a growing popularity of “quantitative easing” as well as new Covid-19 infections remains the starting point for spotting risks and opportunities.

With emerging-market seas calming, investors should behave like master navigators and use all available navigational instruments to plot their course. Avoid the easy approach of running downwind with all sails set, as an unseen reef could sink the boat. Instead, sail on a broad reach and take the occasional beat to windward in order to reach your destination.

1. In April and May 2020, Vontobel and Longitude, a Financial Times company, surveyed 300 institutional investors and discretionary wealth managers across 18 countries. The details are available in the white paper Fortune favors the bold – active investors start to seize the opportunity in emerging markets.
2. Carmen Reinhart and Kenneth Rogoff “This Time Is Different – Eight Centuries of Financial Folly”, (2009), analyzing 66 countries, 250 sovereign external debt default episodes between 1800-2009 and 68 cases of default on domestic public debt.
3. “Modern monetary theory – how do we get down from the debt mountain?” Vontobel, October 2019

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