Outlook 2018 - Emerging market debt: Treading carefully after a strong year

Outlook 2018 - Emerging market debt: Treading carefully after a strong year

Emerging market debt remains one of the last available sources of attractive yield and diversification. But, as inflows continue and valuations rise, the relative attractiveness of the asset class does warrant a more cautious stance.

What is your investment outlook for emerging market debt in 2018?

Five key factors led EMD to perform well in 2017:

 investors’ continued hunt for yield,
 the ongoing effects of China’s credit expansion in 2016,
 a weak US dollar,
 improving global growth momentum, and
 contained inflationary pressures.

Flows into the asset class followed, hitting record highs for the last five years (chart 1). But this picture is changing as some of these tailwinds subside.

China has drastically reigned in its credit expansion, US dollar liquidity is set to tighten significantly into 2018 as the Fed reduces its balance sheet, and growth momentum is showing signs of having reached a peak. Thus, a more cautious stance is warranted as we move into 2018 - the best may be behind us.

These macro headwinds for the asset class emphasise the need for active, bottom-up, country selection to deliver alpha. In this way, I still see pockets of opportunity in certain markets where risk premiums appear mispriced and relative value positions can add value.

While valuations may seem rich in a historical context, the yield and diversification benefits offered by the asset class remain attractive to many investors struggling to generate returns from developed market fixed income.

Chart 1: Flows into EMD at highest levels for over five years in 2017

Source: Fidelity International, JP Morgan, as of October 2017.

What do you think could most surprise investors next year?

Given our expectations for some reversal of the tailwinds which have supported the asset class, an adverse impact on EMD could surprise many investors who have focused on improving EM sovereign balance sheets and growth prospects.

In terms of foreseeable risk, central bank and government policy surprises are the number one risk on my mind, in particular, G4 central bank tightening. US rates are currently pricing in one hike in December 2017 and one more for 2018; a more aggressive Fed could surprise investors and potentially lead to outflows from EMD. Policy making in China also needs to be watched closely.

Finally, investors need to consider the rising beta component of returns. Passive flows into EMD comprised around 25% of flows into the asset class as of November 2017, and, whilst still below EM equity passive flows (60% of the total), this increasing share will likely push up the beta component of returns for the asset class. In a downturn, the largest constituents of the benchmark could be hit very hard if we start to see outflows from some of the large passive vehicles.

How do you plan to capture the best opportunities and add value for investors?

As a portfolio manager, I see my role as protecting investors from various risk factors while aiming to deliver consistent alpha. I remain focused on individual country selection with a high degree of diversification rather than taking large directional bets. Given the outlook described above and my active approach to risk management I am defensively positioned at this juncture.

In local currency, I am underweight in EM FX beta, meaning that if the US dollar appreciates, typically bad for EM, the fund should outperform (ceteris paribus). In hard currency, I am underweight credit risk, as measured by duration times spread (DTS - a measure of credit risk), meaning that if spreads widen, the fund should outperform.

However, I am still finding interesting opportunities in this diverse asset class. For example, due to continued spread tightening through 2017 for sovereigns, I think EM corporate debt offers better value thanks to high carry and lower volatility.

In local currency, I have been increasing exposure to inflation linked bonds as breakeven inflation has fallen and linkers are likely to outperform nominal bonds should EM currencies come under pressure again.

STEVE ELLIS is a portfolio manager at Fidelity International, having joined the company in June 2012. He is the lead manager of several emerging market debt funds. Previously, Steve worked as a portfolio manager at Goldman Sachs Asset Management from 2006 to 2012. He started his career in 1993 within economic and market research positions at NatWest Markets, ING Barings and Lehman Brothers. Steve holds a BSc (Hons) Economics from Bristol University.



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