Why now is not the time to doubt emerging markets

We are seeing the winding down of US quantitative easing, some signs of the Chinese economy slowing, and geopolitical tension in Russia, Ukraine, Turkey and Thailand.

In addition, the political calendar has been particularly busy, adding further uncertainty. The year has brought key elections in Thailand, Turkey, Hungary, India, Indonesia, Egypt, South Africa and Ukraine.

Yet in the year to date, EMD has generated one of the highest returns among broad corporate credit sectors. 

Institutional investors are moving back into undervalued sectors as they seek out cheap valuations

To understand this performance, investors should not forget the strong base case for emerging markets, despite the concerns caused by recent events.

Reasons to be cheerful

Emerging market companies are less indebted than their developed market peers.

High-yield EM companies have more than twice the cash-to-debt levels of their US peers, and over the past 10 years the average high-yield default rate in emerging markets has been lower than global, US and European rates.

Studies from the International Monetary Fund show EM economies account for approximately 45 per cent of global growth – up almost 20 per cent in the past decade.

Leading emerging nations such as China, India, and Mexico look set to contribute further, following structural changes and reforms enacted this year.

Emerging markets’ demographics are also set to support continued growth. The Boston Consulting Group estimates that the nascent middle class in China and India alone will reach 1bn people by 2020, forming a consumer market worth $10tn (£6tn).

Yet many investors have little or no direct exposure to EMD. The perception of this asset class is that of higher risk and thus justifiably higher yields. 

We believe the risks are arguably lower than many perceive them to be, and that current yields represent extremely good value.

The yield-to-worst – the lowest yield that can be achieved without the issuer defaulting – on a crossover investment grade and high-yield EM bond index with a blended investment-grade rating is currently higher than that of pure high-yield indices in both Europe and the US.

This is an important comparison as it demonstrates that not only are investors better compensated with yield for owning EM debt, but that these yields can be gained through higher-quality, and shorter-duration, credits.

Emerging market spreads per turn of leverage are also approximately double that of developed market bonds, meaning EM issuers offer significantly higher yield per unit of risk than developed market counterparts – taking leverage as a proxy for risk.

Institutional investors are moving back into undervalued sectors as they seek out cheap valuations, which should help drive further performance in the asset class. 

Following sustained outflows in Q1 2014, there were positive fund flows into EMD through April and into May.

This change in sentiment towards the asset class is likely to continue. If it does, flows could soon move into net positive territory year-to-date.

The case for value will help drive EM performance. Despite geopolitical turmoil and the withdrawal of western monetary stimulus, returns from EMD have continued to keep step with developed markets.

The positive momentum of EMD, coupled with current valuations, default rates and credit fundamentals, gives investors the opportunity to earn attractive risk-adjusted returns, while diversifying portfolios.

This is something institutional investors seem to be increasingly recognising, as evidenced by recent flows into the asset class. 

Warren Hyland is a portfolio manager at Muzinich