New Tools for Asset Allocators
The rise of local fixed income markets has already given asset allocators a new set of tools, enhancing their ability to construct portfolios with better risk-adjusted returns. Although correlations tend to be high between EM equities and fixed income, investors are starting to find new diversification opportunities across asset classes and local markets.
Country differentiation is digging deeper as well. Market drivers in different countries tend to be more local and idiosyncratic than ever before, from politics in Turkey, to the effects of China’s growth on commodity exporters like South Africa, to the credit cycle in Brazil.
Beyond short-term market movements, countries are increasingly being judged by the policy decisions that they make rather than factors outside their control.
As policymakers in some countries develop more credibility in setting monetary policy, there will be greater divergence with other risky assets as well as country by country. If growth is expected to accelerate in Mexico but flatline in Russia, for example, investors have more opportunities to differentiate between the two scenarios, both because of interest rate differentials and because of greater liquidity in debt instruments, interest rate derivatives and currency markets.
Near term, given uncertain growth prospects and rising rates, EM fixed income’s risks are all too apparent. Yet, with deepening differences among countries and changing dynamics in asset prices, opportunities should appear as well.
Conditions Favorable For Active, Flexible Strategies
Finding relative value requires both an understanding of the fundamentals and insight into local policy and currency markets. For those so equipped, the environment could be ideal for pursuing active and flexible investment strategies.
For EM countries, outcomes will depend largely on the capacity of authorities to adjust and adapt domestic policy tools. Those countries that rise to the challenge with sound policy choices stand to be rewarded.
As local markets have sold off since last May, investors should look for places in which confidence on policy-making is being restored. The prospect of a new reformist administration and the possibility of inclusion in global fixed income indices make the high-yielding local debt of India an attractive proposition. Recent volatility in the currency and cyclical weakness of the Brazilian economy are providing a great entry point for investors that have the appropriate medium term horizon. With five-year bonds offering 6 percent real rates and 12 percent nominal rates, combined with a central bank that has a credible inflation targeting regime, relatively low debt ratios, we think Brazil local bonds should be a core holding for fixed-income investors. Nigerian bonds have also become an attractive investment alternative. Now the biggest economy in Africa, Nigeria benefits from high growth, a current account surplus, ample FX reserves and low debt levels. Their five-year bonds offer 13.5 percent yield, in a context of good market liquidity, a solid and well regulated financial sector and inflation under control around 8 percent.
Along with new opportunities for diversification and returns, we believe the development of local currency fixed income markets is providing emerging economies with a more solid macroeconomic backdrop. As local foundations continue to strengthen, we look for local business cycles to become the most important determinants of local financial asset prices.
This won’t happen overnight, and the transition will be neither uniform nor smooth. But over time, the more local rates come to reflect local economic conditions, the more attractive these markets will become to patient global investors seeking growth and diversification.
Gerardo Rodriguez, managing director, is senior investment strategist and business manager of BlackRock's emerging markets group. Sergio Trigo Paz, managing director, is head of BlackRock's emerging markets fixed income within its portfolio management group.