Investors need to treat emerging market debt with caution following a strong period of performance in 2016, with the more hawkish tone now emanating from the US Federal Reserve a potential threat.
Emerging market debt has delivered double-digit returns year to date, with the JP Morgan Emerging Market Bond Index Global Diversified returning 14.2%.
Such eye-catching gains – ahead of many types of fixed income, as well as other asset classes – have prompted increased interest from investors, with emerging market debt seeing 11 consecutive weeks of inflows.
However, risks are now emerging which threaten returns. This shift in the Federal Reserve’s stance – and recovering US inflation data – are a rising threat to the sector.
A recent shift to a more hawkish tilt by the Fed, coupled with an upward trajectory for core Personal Consumption Expenditures (PCE) inflation, are early warning signs for emerging markets.
Both represent rising threats to the sustainable nature of the performance of the higher yielding portion of emerging market bonds in particular, where spreads reflect levels which are currently ‘overbought’.
As well as a potential threat from shifts in central bank policy, are a number of other risks for the sector.
Banks in some emerging markets had issues with an increase in the number of non-performing loans, while there is also a risk that growth expectations may not prove to be all that sustainable.
We note that these growth levels are being revised higher from what are traditionally very depressed levels for emerging markets, and to us this revision represents more of a bottoming in growth than a growth rebound per se.
With a variety of potential headwinds, it is important to be selective. Our investment approach is focused on extracting sensible emerging market growth premia from a vast opportunity set, as part of a well-diversified investment portfolio which allows an investor to generate competitive performance but protect against the credit risks we have highlighted above.
Countries such as Indonesia, India, Peru, Colombia, Romania and the Philippines all represent much more sensible allocations for an Emerging Market portfolio, and by having an investment grade focus when it comes to assessing emerging markets, it can generate a performance which is better than investing in an index which now has almost 50% in junk rated bonds.
Scott Fleming, manager of the Kames Emerging Market Bond Fund at Kames Capital