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A renaissance for emerging markets on the back of a weaker US dollar is proving a very happy birthday for Robeco’s Emerging Debt fund.
The fund, which buys the debt of governments and companies in Latin America, Central Europe, Africa and Asia, has celebrated its 5th anniversary with a strong track record of outperformance. And that is set to continue as emerging markets look forward to a declining US dollar and higher commodity prices fueled by Chinese growth, says portfolio manager Paul Murray-John.
“The market in 2016 has been super-strong, with record inflows into emerging markets debt across local currency, hard currency, sovereign and corporate asset classes,” says Murray-John, who has managed the fund since February 2015.
“And this comes at a time when many fund managers have been at best neutral and probably a bit underweight on emerging market debt. The most obvious reason for this is the search for yield, at a time when there are negative interest rates in Japan and the Eurozone, and both the Bank of England and the US Federal Reserve are sounding dovish after the Brexit vote. Investors are seeing this has an opportunity to earn some meaningful yield.”
The fund returned 12.82% in the first six months of 2016 compared to 11.77% for the benchmark. Since its inception, poor conditions for emerging markets hit by a strong dollar and low commodity prices a few years ago has generated a net return of -2.25% on an annualized basis, though still outperforming the benchmark’s -3.41%.
“The outperformance has been pretty consistent over the whole period,” says Murray-John. “We looked at the types of markets in which the fund does well and found that it performs strongly in both up markets or down markets, with relative underperformance usually coming when the market is range bound. Intuitively this is because we are taking active positions rather than relying on ‘buy and hold’ carry strategies .
“Essentially we’re looking for opportunities where risk is under or overpriced, and most of the time judging our risk in terms of where we are positioned relative the index. These active positions will pay off in an up market or down market, but can cost us relative performance when nothing happens.”
He says there are three big global themes currently which are positively affecting emerging markets as an asset class that should play out for the coming year at least. “The first is the Fed and the outlook for its policy,” he says. “Then there are improving commodity prices, and not just oil, but in metals as well. These higher commodity prices have been caused by the third reason, the outlook for Chinese growth. All three are positive for emerging debt prices.”
“The Fed is sounding more dovish and now there’s only one rate hike expected and not until 2017. That’s a big change from earlier in 2016 when we were pricing in two hikes for this year. It caused a rally at the front end of the US rate market and that has weakened the dollar, which has benefited emerging market currencies, which have all strengthened. And bond prices have rallied on the lower US yields.”
‘Commodity prices have rallied on the spending boom in China’
“We’ve seen the oil price bounce to around USD 50 a barrel because the imbalance between demand and supply has changed – oil production capacity has been taken out as companies have cut investment spending and oil rigs numbers have been dropping, while there has been a simultaneous increase in demand for refined gasoline.”
“Other commodity prices for copper, iron ore and other building materials have rallied on the spending boom in China. The Chinese government said it would deliver on 6.5% growth this year, which has required a massive boost in government-led investment spending on new infrastructure projects, which is also driving a big rally in house prices. Consequently, copper, iron ore and steel which are needed to build houses have jumped in price. It has meant higher demand for emerging market exports which to a large extent are commodity related.”
The depreciating dollar greatly benefits the fund, which has 85% of its assets in government debt that is denominated in local currencies. About 5% of assets is in sovereign bonds denominated in US dollars or euros, as is a 10% allocation to corporate bonds. This exposure to the US dollar and euro is currently fully hedged back into local currencies.
Favored countries in Latin America are Brazil, Mexico and Columbia, while in Central Europe and Africa the fund invests in debt in Turkey, Poland and South Africa. In Asia, the top three countries are Indonesia, Malaysia and Thailand. “The corporate bonds have a similar country allocation to the overall fund, and with a sectoral focus on oil & gas, utilities and basic industries the credit exposure has a quality bias, which is what you need in a fund that is designed to deliver attractive risk returns compared to a local market benchmark,” says Murray-John.
The attempted coup in Turkey showed that any form of emerging market investing carries risk, so the fund uses data from RobecoSAM’s Country Sustainability Ranking (CSR) to try to narrow it down. The CSR uses advanced metrics to measure the environmental social and governance (ESG) problems in the countries that it covers.
‘The places with poor ESG scores tend to perform poorly’
“ESG analysis is very important in emerging markets because the places with poor ESG scores tend to perform poorly over the medium to long term,” says Murray-John. “As well as ESG factors we base our fundamental bottom-up country research on two other factors: debt sustainability and the economic cycle. These three factors together are called the ‘three pillars approach’.”
“There are no off-limits countries for investment, but we are very aware of the key role that ESG, and particularly the governance risk (in other words political risk), plays in a country’s outlook. Venezuela and Nigeria fail the ‘G’ test, so we own nothing there. Concerns for the ‘G’ score on South Africa led us to underweight the country, and we had reduced our weighting to Turkey before the attempted coup in July.”
“In the future, political risk – as was dramatically seen with Turkey – is the biggest issue for us currently, along with the potential risk of emerging market central bank intervention to weaken their currencies. It remains a challenging global growth environment, in which China is managing the renminbi weaker, so there is a strong incentive to devalue your currency. But we firmly believe that most emerging market central banks will resist any dramatic weakening of their currencies versus the dollar from current levels, particularly if there is any sign of accelerating inflation.”
Looking forward to the next five years, Murray-John thinks that what happens in the US and China will continue to lead sentiment in emerging debt markets. “The big negative for emerging local debt in recent years has been the currency weakness against the strong dollar following the start of the tightening cycle,” he says. “But the high yields that investors are now getting, especially when compared to the pitifully low yields in developed bond markets, will most likely more than compensate for any residual dollar strength.”
‘We see some signs of decelerating growth in the US’
“We see some signs of decelerating growth in the US; which is not surprising given the age of the current expansion, so the dollar is unlikely to continue to perform strongly, particularly if the US is not hiking rates. Many emerging market countries are seeing an improvement in their terms of trade as commodity prices recover, and there has been an associated improvement in current account deficits.”
“This trend should continue now that Chinese policy makers are fully focused on delivering their economic growth target. We think the future is bright for this asset class, and we have proved over the past five years that with an active investment process we can successfully identify, and profit from, mispriced risks, whatever the market cycle throws at us.”