Compelling case for inflation-busters

This year has proved volatile for many risk assets, driven initially by uprisings in the Middle East and several tragic natural disasters in the Pacific region. This has been exacerbated by a refocusing of investors’ attention on the debt crisis in peripheral Europe and a raft of weaker economic data coming from America.

Despite this volatility, the fixed income asset class has been resilient, in particular when considered in the context of the fourth quarter (Q4) of 2010 when American government bond yields spiked by about 1% or Q2 2010 when the impact of bail-outs in the European periphery led to significant spread widening. Emerging market debt is a case in point and over the first quarter of 2011, external debt spreads were unchanged compared with Q2 2010 when spreads widened by 99 basis points. According to the JP Morgan GBI-EM Global Diversified index, local currency bonds have returned 0.5% over Q1 2011 compared with Q2 2010 when they shed 0.5%.

Little has changed to alter the strong fundamental case for emerging market debt. While some western econ­omies introduce austerity measures, emerging econ­omies remain in a stronger financial position than their developed counterparts, most of which are saddled with enormous government debt after the credit crisis. Emerging Asia, for example, has among the highest savings rates globally and runs large current account surpluses with significant and increasing foreign currency reserves.

By contrast, debt to GDP in Greece is predicted to reach 150% over the coming few years yet the announcement earlier this year that the interest rate on the International Monetary Fund/European Union bail-out would be reduced by 1% will take just 3% a year off the Greek deficit. Greater financial security in emerging markets is coupled with favourable economic tailwinds, such as the increased share of GDP that consumers are expected to take. (Trends continues below)

What has changed since 2010 is behaviour among fixed income emerging market investors compared with their equity counterparts. According to EPRF, withdrawals from global equity funds totalled $7 billion (£4.3 billion) in the week to May 22, 2011, of which $1.6 billion was from emerging market equity funds, whereas emerging market fixed income funds have seen net inflows of $7.9 billion in 2011 to date.

This trend is important and is evidence of the structural shift as investors redress their underweight position to emerging market fixed income. Trends such as this are important because they create a natural buyer base, which supports asset prices. With the average American pension fund allocating just 1% of its fixed income allocation to emerging market debt, this trend looks set to continue as long as emerging market growth fundamentals continue to exceed those of developed markets.

In addition, valuations remain attractive. The emerging market debt asset class offers not only higher yields compared with developed markets, but in the case of the local currency part of the asset class, it also offers exposure to potential appreciation in emerging currencies, and therefore capital gains, many of which remain undervalued.

Issuance of local currency bonds has increased substantially over the past decade as emerging countries’ credit fundamentals have improved and investor demand has grown, trends that are expected to persist. Indeed, local emerging markets are about three times the size of dollar emerging markets. Moreover, countries that issue local currency bonds have their own yield curves, so have a low sensitivity to American bond yields and a lower correlation to other fixed income asset classes offering investors protection from rising American bond yields that trade at record lows.

Of course, risks remain, in particular rising inflation driven by strength in emerging economies, abundant global liquidity resulting from programmes such as quantitative easing and food and energy price increases in the wake of oil prices exceeding $100 a barrel. The latter are particularly important in emerging markets because a greater proportion of emerging market inflation baskets comprise food and energy.

Bond markets have moved to price inflation risk and in some cases to price the risk that emerging market governments do not tighten policy enough to contain the threat. This risk should not be ignored and while it is correct to note that the base effects of oil and food price increases should pass in the second half of 2011, agricultural inventories remain low exerting upward pressure on prices.

However, over the past decade, emerging market governments have gradually enhanced their credibility with investors by instigating sensible policies to target inflation and by establishing independent government financial institutions, reducing the interest rates demanded by investors to lend to them. To this end, many emerging countries have embarked on a rate hiking cycle as they seek to cool their economies and prevent unwanted inflation.

Research from Ashmore has noted that emerging market interest rates have increased by 87bps over the past year. This is creating a virtuous circle as rising interest rates are positive for currencies and lend these markets greater inflation-fighting credentials. Emerging market currency appreciation is itself a valid policy tool for fighting inflation as rising exchange rates temper the demand for their exports.

On balance, the outlook for emerging market debt remains compelling, especially for local currency emerging bond markets. Not only are investors’ significant structural underweight position in emerging market debt driving positive inflows, but fundamentals continue to improve.

The economic and financial strength of emerging economies relative to their developed counterparts, and the increasing share of global GDP they are set to gain, together with undervalued currencies and rising average credit quality, combine to create a strong long-term investment case for the asset class.

Anthony Gillham is a portfolio manager and investment analyst at Skandia Investment Group.