Since the start of the financial crisis last summer, credit spreads have widened dramatically, global equity markets have been pummeled and major banking systems have come under repeated and unrelenting pressure. The bursting of the US housing bubble has already inflicted immediate and far-reaching pain on the US financial sector, and growing evidence indicates that the problems faced by the financial system are spilling over into the broader US economy as the credit crunch takes its toll on the locomotive of global growth: US household consumption.
Amidst all this turmoil, a low-simmering debate has persisted about the "decoupling" of emerging market economies, and by extension, emerging market fixed income (both hard currency and locally denominated), from the financial crises dominating the industrialized world. While emerging market fixed income, commonly referred to as emerging market debt or "EMD," has experienced an increase in volatility, illiquidity and spread, the asset class has been a relative bulwark of stability in a deteriorating neighborhood. Can EMD continue to outperform in the face of increasing external risks? We believe the answer is "yes". Barring a catastrophic drop in global growth, we believe EMD outperformance is likely to continue.
At the far end of the "coupling vs. decoupling" debate, skeptics have contended that EMD would fall out of fashion alongside evaporating liquidity and risk appetites; plunging asset prices would lead to deteriorating economic fundamentals, and in the worst cases, would herald a return of old-fashioned boom/bust cycles and emerging market balance-of-payments crises and default. On the other side of the debate, emerging market advocates (like Goldman Sachs Asset Management) argue that the strengthening in country balance sheets have made sovereign fundamentals more resistant to shocks and have helped diffuse the potential for a feedback loop in which lower asset prices lead to lower real economic growth. Thus, the emerging market advocates argue that the sector should generally outperform amidst deteriorating credit markets. Emerging markets would not necessarily be immune to a slowdown in the G3 economies (the US, Germany and Japan), but barring calamitous events, we believe emerging market economies should not unravel. As the financial crisis has worn on past its first anniversary, we have seen the outperformance of EMD in the last year settle this debate - at least for the time being - in favor of the emerging market advocates.
How will the debate unfold from here? We believe the final outcome will be a nuanced combination of the two sides to the decoupling debate, significantly driven by the magnitude of economic distress in the G3 economies. We are in the grey area of a moderate slowdown in US growth, but in recent months, growth has slowed noticeably in the UK, Eurozone and Japan. We firmly believe emerging markets can continue to weather a modest slowdown in the developed world. What about the much less benign scenario of outright global economic contraction, particularly one accompanied by plunging commodity prices? A deep and protracted recession in the industrialized world, even if it is contained, is more likely to have an impact in emerging market countries. In an increasingly integrated world where trade and capital flows are a rising share of the global economy, complete decoupling is virtually impossible. Fortunately, emerging market countries' initial conditions are more solid today than in previous global downturns, so we believe a greater disruption will be required to knock emerging markets into an inferior equilibrium. However, we do not expect individual countries within the emerging market asset class to move in lockstep, and believe that credit differentiation will abound based on relative vulnerabilities. Emerging market countries with limited external and fiscal financing needs will fare better than those where more extensive financing needs could be jeopardized by a sudden halt in capital flows.
In this instance, we believe history should not be used as a guide. We see four reasons why EMD spreads will respond differently to a global shock than they have in the past. First, the extent of the global shock is what matters, not just the presence of the shock itself, in determining the repricing of emerging market credit risk. Second, initial economic conditions in the emerging world are better today than they were at the start of previous shocks, as evidenced by improved external and fiscal solvency and liquidity, fiscal prudence that improves payments prospects and brings down structural inflation, active debt management that improves the payments profile and the accumulation of external surpluses. Today's economic conditions provide emerging market countries more room to employ countercyclical policy to mitigate the negative impact of an imported recession, which should also limit any fall in bond prices. Third, in this challenging investment climate we have seen that even in the worst-case scenario of outright economic contraction, the increasing availability of information means that credit differentiation, and not a wholesale de-rating of the emerging market asset class, is likely to abound. And lastly, the sponsorship of the asset class is far more broadly diversified across long-term strategic investors such as pension funds, central banks, sovereign wealth funds, and even individual investor portfolios than ever before.
In local debt markets, inflation risk - not growth or credit risk - has been the dominant driver of returns this year. Most of the acceleration in headline CPI has come from a temporary spike in food prices, which currently constitute 30% of overall CPI in the emerging markets (compared to just 7% in the US). Across the board, emerging market countries' central banks have tightened monetary policy to stymie the pass-through of headline into core inflation. Inflation risk and monetary policy tightening have led to an overall widening in local debt yields. While there has been tremendous variation across emerging market countries, on balance, their central banks have been largely ahead of the curve in combating the transmission of the commodity shock into core inflation. The agricultural supply response to higher prices has already filtered into larger expectations for year-end harvests (the risk to this remains the weather), which we believe should reduce inflationary pressures by year-end. A deceleration of growth towards trend should also serve as a natural harness to inflationary pressures.
In recent weeks, the pendulum of risk globally has swung from creeping inflation towards lower growth, resulting in plunging commodity prices and one of the highest monthly returns in emerging market local debt markets as yields collapsed. We think it is still too early to call a turn in the balance of risks for emerging economies, but think the structural argument for lower inflation - underpinned by productivity growth outpacing wage gains and sensible fiscal policy - will prevail. In our base case, we see modest outturns in inflation and growth, instead of extreme volatility in the business cycle. We believe this moderation in the business cycle - evidenced throughout this decade - will be the main keystone for modest and stable risk premia for both external and local EMD. Yields have not fully priced these improvements in, and combined with expected currency strength from external surpluses and productivity outperformance, the structural return for local EMD markets remains very compelling.
The relative outperformance of EMD as an asset class during a period of acute global financial stress has demonstrated the improving economic fundamentals of emerging market economies and the deepening maturity of EMD. A strategic allocation to EMD is being embraced by institutional and individual investors alike. As a result, strategic flows into EMD - both external and local debt allocations - have multiplied in the last few years, and still persist in this climate of heightened global fundamental risk. This marked increase in EMD adoption should only help to reinforce the case for long-term allocations to the asset class. Moreover, the increase in new allocations from institutional investors (who, it is important to note, are still underweight EMD compared to the sector's share of the global financial markets), combined with limited sovereign financing needs, provide an underlying technical base for the asset class. In our view, all these factors help make the case for Advisors to consider this asset class as a core holding in individual investor portfolios. In contrast, given the relative outperformance of EMD, the tactical argument for EMD at present has been less compelling, and such tactically-driven flow less abundant. We believe a portfolio allocation to EMD is more a long-term view of economic convergence that should bring down yields and volatility, rather than taking advantage of short-term anomalies. In an environment where shocks resonate both to the upside (better growth, lower inflation) and downside (lower growth, higher inflation), such a cautious long-term orientation may warrant serious consideration.
Owi S. Ruivivar is a portfolio manager on the emerging market debt team for Goldman Sachs Asset Management (GSAM).