Perspectives from ISB

Emerging markets have outperformed developed markets in 2012, with EM equities returning 18% (versus 16% for developed world equities) and EM dollar (and local currency) bonds also returning about 18%. So what does the outlook hold for 2013? Michael Gomez, head of EM investment at PIMCO (, looks at drivers of return in 2012 and  identifies the areas of opportunity for 2013. To summarise:

-2012 was an exceptional year for all EM asset classes-driven by excess liquidity created by central banks in the developed world,  as well as  by central banks in developing countries which  eased aggressively in reaction to the pronounced economic slowdown leading to a surge in EM bonds and equities during the second-half of last year.

-The value proposition for EM assets was a higher current return, cleaner balance sheets and the  prospects for higher growth.  This feature, combined with negative real interest rates  in developed world government bonds caused by financial repression, pushed investors to allocate record  amounts to EM bonds ($94BN), in particular doubling inflows into EM  external bonds.

-The multi-year outperformance by EM external debt has been characterised by improving credit quality and falling yields – with the market bond index at the end of 2012 having a composite credit quality of BBB-, an  average duration of 7.7 years and a yield of 4.5%.

-However, the  index includes a high weighting to Venezuela and Argentina, both higher risk countries and excluding them would reduce the yield to a less attractive 3.8% and an increase in duration to almost 12 years with a BBB credit quality. This makes the index at fair value when compared to investment grade alternatives in the developed world.

-In the high yield sector , the EM index has a duration of 7 years, a BB+ rating and a spread over  U.S. treasuries of only 2.74%,  which compares poorly to developed world HY indices which have shorter duration and higher spreads.

-However, one sector which continues to offer attractive valuations are  EM corporate bonds which offer similar yields to EM sovereigns but with a one notch higher credit rating and 1.5 years less duration.  In addition, EM corporate  bonds provide an attractive pick-up over developed world corporate debt.

-While EM local debt has had outstanding performance in 2012, the sector continues to offer attractive value with a credit quality of BBB+, a short duration of 5 years and an aggregate local currency yield of 5.5%.  In addition, the index is not skewed by a few countries and 90% of the index is made up of countries with at least one investment grade rating.

-Investors moving from developed world government bonds into EM local debt pick-up over 4% of yield and lower duration by approximately 2 years.  While the current credit quality of EM local debt is lower than that of the developed world, the rating differential is rapidly  converging.

-EM local debt also offers the possibility of currency appreciation – with developed world currencies being debased by central bank policies and EM countries offering higher growth , capital inflows and a tightening bias by central banks if global growth surprises on the upside.

-While EM quities performed well in 2012, being a warrant on EM growth, they have underperformed over the last few years following downward economic growth adjustments.  This has made the EM  equity index offer attractive valuations  with a forward P/E of 11 times (about 1 standard deviation below the historical average), which is at a discount to EM historical levels as well as to the world equity index.

-In particular, EM cyclical stocks  are poised for superior performance as they are coming off a 2 year period of flat earnings growth and a pick-up in EM and Chinese growth, excess liquidity and low interest rates should provide a supportive environment.

-EM growth prospects remain attractive, driven by long-term secular trends in wage growth and urbanization to offset structural challenges of the middle-class transition in China and the  likelihood  of prolonged subdued growth in the developed world.

A succinct analysis of why having a significant weighting in EM equities, local currency bonds and select external EM corporate debt continues to make sense, despite a stellar performance in 2012.  An important point not made in the above analysis (and made in a newsletter  from late 2012 which summarised a PIMCO note Inflation Regime Shifts: Implications for Asset Allocation) , is the added feature of EM currencies providing a hedge against eventual  higher inflation in the developed world.  While inflation remains subdued, and is likely to remain so for a few years more, it is likely to dominate the investment horizon over the second-half of this decade – ravaging portfolios without adequate allocation to commodities, commodity equities and  EM local currencies, and  with excess allocations to long duration bonds.  In addition, while equities are likely to initially underperform in an environment of higher inflation, having adequate allocations  to equities today provides an opportunity to build a substantial buffer as a result of the ongoing cyclical bull market.

An international bond fund with a long and successful track record  (12% per annum over 5 years) and which provides exposure to mainly non-$ and non-Euro global bond markets is the Templeton Global Total  Return bond fund (TGTRX) which is exposed to EM local currency bonds and  select developed market local currency bonds, issued by government as well as corporate. An ETF which provides exposure to 8 local currency Asian government bonds (China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand) is the ABF Pan Asia Bond Index Fund (2821.HK) . The ETF pays  about a 3% dividend yield and has returned 6% per annum (9% with  dividends)
over the last 5 years.

As the chart below illustrates clearly, EM countries (and in particular the BRICS)continue to be the drivers of global economic growth.  Institutional investors in the developed world continue to be grossly underweight in EM equities and bonds (as detailed in  a previous newsletter from 2012), compared to their contributions to global growth, and they are likely to only increase this allocation over the course of this decade.

-In addition to offering higher economic growth, EM corporate also provide superior Earnings per Share (EPS) growth with lower volatility (including China) when compared to the developed world.