Having been cautious on the asset class for years, Robeco Global Total Return Bond Fund has recently built up a 6% position in local emerging debt. The investment team is becoming more constructive on emerging debt because of its attractive valuations, the first signs of inflows back into the asset class and a recent improvement in fundamentals.
Emerging debt’s valuations have become quite compelling. As yields have been rising and foreign-exchange rates have been going down since mid-2011, the asset class has been faced with substantial outflows over this period. Its underperformance was mainly driven by the global economic slowdown particularly in China, which affected emerging markets more than their developed counterparts. Whereas growth in emerging markets was decelerating, the US and parts of Europe have been showing signs of a turnaround.
In addition to valuations, there are also some macro-economic developments favoring emerging debt. One of them is that yields in developed markets are declining. The Fed has becoming decidedly less hawkish in its recent statements, adjusting its growth forecasts downwards. A Fed rate hike in 2016 has become less likely. Consequently, investors are looking for yield elsewhere, which they find in emerging debt.
The fact that China has recently become more growth-focused in its economic policy also helps. The National People’s Congress decision to increase fiscal spending and recent monetary policy loosening by the PBOC to boost the economy have had a very positive impact on many local emerging market bonds and exchange rates this year.
There are also signs that most commodity prices have bottomed out. Monetary relaxation by the Chinese has pushed up house prices, boosting the demand for copper and iron ore, for example. Combined with some supply reductions and talk of an OPEC + non-OPEC agreement, this has pushed general commodity prices higher and helped many emerging market FX rates to rally.
Apart from these valuation-related and fundamental considerations, the technicals are also improving. Outflows have been declining and have recently even turned into inflows. A case in point is Japan, with its negative rates, where banks have been moving into higher yielding assets, including emerging debt.
There are risks, though, of which China is an important one. Although the People’s Bank of China is doing an effective job in managing the short-term challenges of the economic slowdown, the long-term reform of the state-owned enterprise sector will need more work.
The Chinese government is committed to reforming the economy from an investment-led production focus to a more consumption-based model. This is good in theory but is proving difficult and disruptive to achieve in practice. The biggest challenge is that this transition implies large job losses at industrial state-owned enterprises as they reform or close, which will increase unemployment and threaten social stability. A potential large future renminbi devaluation, which we deem unlikely, might send investors back into risk-off mode. However, to partially address this risk, the Robeco Emerging Debt fund has recently taken a short position in the yuan as the cost of hedging has dropped significantly over recent months.
Another caveat is that, although emerging debt is a highly diverse asset class about which it is tricky to make general statements, several emerging countries have borrowed significantly in recent years and need to delever. For example, the Chinese corporate sector and the Malaysian sovereign have borrowed worryingly large amounts of USD-denominated debt.
Finally, because of the depreciation of emerging currencies since 2011, some signs of domestic inflation have emerged, caused by rising import prices. Governments have not been too keen on addressing this issue, as it actually helps them to boost economic growth. Nevertheless, some Central Banks have already been hiking rates, especially in Latin America (i.e. Colombia, Peru and Mexico). The Robeco Emerging Debt fund is overweight in the long end of the Peruvian and Mexican curves, which profit from hikes in short-term rates.
Robeco Global Total Return Bond Fund uses the Robeco Emerging Debt fund to gain exposure to emerging debt. This fund invests the majority of its portfolio in local currency sovereign debt, supplemented opportunistically with hard currency emerging sovereign and corporate credits. It pursues an active and flexible analytical approach, which is fully integrated within Robeco’s global macro investment process and focused on identifying countries where economic or political change mean risk is mispriced.
The PBOC’s decision to support the renminbi while loosening monetary and fiscal policy has set off a strong rally in local emerging markets bonds and currency rates this year. Although this is a positive sign we are watching for confirmation that economic activity in China and across the rest of Asia will start to improve. In the long term it does raise some risks that China fails to rebalance its economy away from investment and towards consumption. This leaves us cautiously optimistic on the asset class at this point.
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