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Considering Emerging Markets? Bonds May Be Preferable To Equities

With the U.S. bond market suffering its worst quarterly loss in four decades in the first quarter and the S&P 500 and NASDAQ

off to its worst start in decades, investors are looking for ways to protect their portfolios. One reason to consider emerging markets (EM) is they are less highly correlated with U.S. markets than other advanced economies and thereby offer added diversification benefits.

The big question is whether EM assets can outperform U.S. stocks and bonds. As shown in the table below, returns for EM equities have trailed those in the U.S. considerably for more than a decade now, while EM bonds have fared relatively well versus U.S. bonds until this year when Russia invaded Ukraine. Note that the EM bond returns shown are for sovereign debt that is U.S. dollar denominated and which are generally governed by U.S. or U.K. laws.

Table 1. Investment Returns by Asset Class (annualized total returns in %)

The heyday for investing in EM equities was the first decade shown when U.S. stocks were rocked by the housing bubble that led to the Global Financial Crisis in 2008. EM equities outperformed both U.S. and international equities handily during that stretch. China emerged as an economic superpower following market-oriented reforms in the 1990s and its entry into the World Trade Organization at the end of 2001. Also, Asian economies recovered from the Asian Financial Crisis in 1997-98 that left their equity markets and currencies considerably undervalued.

Marketers at that time proclaimed EM equities as a growth play and projected the respective economies would grow much faster than advanced economies. In 2001, Goldman Sachs Asset Management coined the acronym BRICs — Brazil, Russia, India and China – for what they considered the leaders to be and launched a fund that invested exclusively in these countries. However, when conditions reversed the following decade as Brazil and Russia encountered problems and China’s economy experienced a growth slowdown, Goldman wound up closing its fund in 2015.

Meanwhile, the U.S. stock market has far outperformed EM equity markets. This has continued during the Covid-19 pandemic as many EM economies were hit hard and government finances deteriorated. EM central banks, in turn, have had to contend with accelerating inflation, and both the World Bank and IMF have warned that middle and lower-income economies could experience recessions in 2022-23 and slowdowns. Accordingly, EM equities do not seem poised for a quick improvement.

My take is that in these circumstances is investors may do better to consider EM debt instruments with the goal of matching or outperforming U.S high- yield (HY) bonds. Currently, both B-rated and BB-rated EM sovereign bonds offer good relative value versus comparably-rated US HY instruments for 5-year maturities, while single A-rated instruments are expensive. Also, because the EM yield curve for sovereigns is currently steep by historic standards, the incremental yield is greater if investors are willing to extend out to 10-year maturities or beyond.

With respect to corporate debt, EM corporates typically maintain much lower leverage overall than US corporates, whether investment grade or HY. Historically, the risk reduction from having lower leverage has helped to offset higher currency risk and political risk associated with emerging economies.

An important difference today from the past is that emerging economies in Asia and Latin America have become less dependent on foreign capital since the Asian Financial Crisis, and many permit greater exchange rate flexibility to serve as a shock absorber. Also, the Covid-19 pandemic resulted in steep declines in imports and increased remittances for many Latin American countries that improved their current account positions, and some are now in balance or surplus. And the surge in commodity prices has further benefitted the current account positions of net energy exporters.

Still, this does not mean that investors can ignore idiosyncratic risks associated with individual countries. The most obvious is Russia, which has suffered from sanctions imposed following its invasion of Ukraine that has left the country headed for a severe recession. Political will and the ability to affect key reforms needed to maintain fiscal discipline are also key factors for consideration.

Brazil could also become a focal point because inflation and interest rates are elevated. The unemployment rate reached 11.2% in February, and the government’s budget deficit is estimated to approach 8% of GDP this year. While Brazil’s currency strengthened against the dollar this past year on the back of higher interest rates, it has come under pressure recently amid concerns about the economy.

Finally, should investors choose to consider EM debt as a way to boost returns while diversifying risk from U.S. bonds, they are well advised to do so using a fund that is experienced and that has a proven track record? Because of the complexity entailed in the analysis of emerging market debt, it is not an asset class for novices.

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