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EMERGING MARKET DEBT TAKES CENTRE STAGE NOW A CORE PART OF THE GLOBAL FIXED INCOME LANDSCAPE

OCTOBER 2019

> Emerging market (EM) economies are taking a more prominent role globally while EM debt constitutes a significant and growing part of the global bond universe. In this paper we examine the factors that drive this asset class.

EXECUTIVE SUMMARY

ECONOMIC EVOLUTION: EM ECONOMIES ARE TAKING A MORE PROMINENT ROLE GLOBALLY

• In nominal US dollar terms, emerging market (EM) economies’ share of global GDP has risen from 20% to 43% or from 40% to 60% in purchasing power parity terms

• Since China’s accession to the World Trade Organization in 2001, EM’s share of global trade has grown from just over 30% to almost 45%

• Twenty years ago most of the world’s bilateral trade was between the most developed countries. Today almost half of bilateral trade now involves at least one EM country

• Although EM government debt is now approaching 50% of GDP, it remains markedly below the 108% level of advanced economies

MARKET STRUCTURE: EM DEBT MAKES UP A SIGNIFICANT AND GROWING PART OF THE GLOBAL BOND UNIVERSE

• Back in 2000, EM debt represented just 2% of the global bond universe whereas today it is closer to 25%. A trend toward greater bank disintermediation should see this continue

• Since the global financial crisis, EM corporate debt has become very much a standalone asset class. It has quadrupled in size, and at US2.3trn, now stands at twice the size of both the EM hard currency sovereign debt and US high yield markets

MARKET BEHAVIOUR: INCOME HAS TENDED TO BE A LARGE DRIVER OF EM DEBT RETURNS OVER THE LONG TERM

• EM debt returns have traditionally been most attractive in hard currency. While EM local currency debt can, at times, generate some of the strongest outright returns, it can also be the most volatile sub-asset class leading to a low Sharpe ratio

• Income has tended to be a large driver of long-term EM debt returns, while spread and interest rate duration volatility dominate returns over shorter periods

• Among the key factors affecting EM debt performance are expectations of the emerging market versus developed market growth differential, US interest rates and the US dollar as well as developments in the domestic EM investor base

1,2 Source: IMF, Insight, August 2019.

CHINA’S ACCESSION TO THE WORLD TRADE ORGANIZATION (WTO) IN 2001 ACCELERATED A SHIFT IN THE

GLOBAL ECONOMY’S CENTRE OF GRAVITY. EMERGING MARKETS ARE NOW MAJOR CONTRIBUTORS TO GLOBAL

ECONOMIC OUTPUT AND TRADE.

THE GLOBAL ECONOMY’S CENTRE OF GRAVITY HAS SHIFTED TO EMERGING MARKETS

The composition of global GDP has changed markedly since

China’s accession to the World Trade Organization in 2001.

In nominal US dollar terms, EM economies’ share of global GDP

has risen from 20% to 43% (Figure 1), or from 40% to 60% on a

purchasing power parity (PPP) basis (Figure 2).

Double-digit growth for much of the last two decades has

propelled China’s economy to second largest in the world in

nominal US dollar terms (US$14trn). However, this is not just a

China-centric story. At US$22trn, the economic heft of EM

excluding China exceeds that of the US and UK combined. India

and Brazil both feature alongside China on the list of the world’s

ten largest economies, with a further six EM economies listed

within the top twenty.

ECONOMIC EVOLUTION

Figure 1: EM share of Global GDP (nominal US dollar)1

0

20

40

60

80

100 Advanced economiesEmerging Markets

202320182013200820031998

%

n Emerging markets (LHS) n Developed markets (LHS)

0

20

40

60

80

100

120

World GDP

World GDP (RHS)

Trillion (USD

Figure 2: EM share of Global GDP (PPP basis)2

0

20

40

60

80

100Advanced economies

Emerging Markets

202320182013200820031998

%

n Emerging markets n Developed markets

FROM EXPORT-DRIVEN TO CONSUMER-DRIVEN GROWTH

Traditionally EM growth has been seen as export-driven, supplying

manufactured goods to meet the demands of consumers in the

US and other developed markets (DM). It was the so-called East

Asian Tiger economies of South Korea, Taiwan, Hong Kong and

Singapore that led the way with this approach to growth from the

mid-1970s onwards. This was followed by a number of export-

oriented newly industrialising South East Asian and Latin American

economies, and most latterly China upon its WTO accession.

Gross capital formation and consumption have since become the

most relevant EM growth drivers however (Figure 3 and 4). We see

consumption’s role as an EM growth driver becoming even more

important over time as these countries continue to urbanise and

their middle classes continue to expand, similar to the trends that

have already been observed in DM.

Figure 3: Real GDP contributors (Top 20 EM ex.China)3

0

2

4

6

8

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

%

-2

n Government expenditure n Consumptionn Gross capital formation n Net exports Real GDP yoy% change

Figure 4: Real GDP Growth Contributors (China)4

02468

10121416

Net Exports

Gross Capital Formation

Consumption

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

%

n Consumption n Gross capital formation

n Net exports Real GDP yoy% change

Real GDP YoY% Change

-1

Net Exports

Lorem ipsum

3,4,5 Source: IMF, Insight, August 2019.

THE RISE OF INTERREGIONAL TRADE

Developments in global trade follow patterns similar to those for

GDP. China’s entry into the global multilateral trading system via

WTO accession was a significant moment. Since that point, EM’s

share of global trade has grown from just over 30% to almost 45%

(Figure 5). And while there are various unknowns clouding the

global trade outlook – US unilateralism/protectionism and the

future of Trans-Pacific trade – we anticipate that the next major

shifts in global trading patterns will come from within EM ex-China.

Twenty years ago most of the world’s bilateral trade was between

developed countries. Today almost half of bilateral trade now

involves at least one EM country. In recent years we have seen a

number of bilateral trade deals strengthening ties between EM

economies. China-Latin America trade, for example, has increased

from US$17bn in 2002 to over US$300bn today, and China has

become the top trading partner of Brazil, Chile, Peru and Uruguay.

Figure 5: Decomposition of global trade5

0

10

20

30

40

50Developed Markets

Emerging Markets

2017201620152014201320122011201020092008200720062005200420032002

n Emerging markets (LHS) n Developed markets (LHS)

0E

10

20

30

40

50EM/World GDP

EM/World Trade

Trill

ion(

USD

)%

EM trade/world GDP (RHS)EM trade/world trade (RHS)

US RETREAT IS CHINA’S OPPORTUNITY

The US withdrawal from the Trans-Pacific Partnership (TPP)

provides China with greater scope to fill the vacuum for East Asian

and Pacific trade. It is already making a push for an alternative with

the Regional Comprehensive Economic Partnership (RCEP), a

potential free trade agreement involving the Association of

Southeast Asian Nations (ASEAN) as well as Japan, South Korea,

India, Australia and New Zealand. If signed, RCEP would

incorporate half of the world’s population and a third of its

economic output. This increasing interregionalism will also, over

time, have meaningful effects on currency trade volumes, trends

already evident for the Chinese yuan.

CURRENT ACCOUNT DYNAMICS: REGIONAL DIFFERENTIATION

Asian economies are wary of current account deficits

During the 1990s many Asian economies became reliant on

inflows of foreign capital, building up large current account deficits

in the process. When investor confidence collapsed in 1997 these

capital inflows reversed abruptly, sparking a balance of payments

crisis. The IMF subsequently stepped in to provide support,

conditional on these countries exercising fiscal austerity and

monetary restraint. This prescription proved controversial

however and made these economies determined to never again

be beholden to the IMF. Since then, South East Asian economies

have become much more savers than spenders.

Latin American current accounts are commodity-sensitive while EMEA’s are a mixed bag

Major commodity-exporting Latin American economies

maintained large current account surpluses during the 2000s

thanks to very favourable terms-of-trade linked to the so-called

‘commodity super-cycle’. Its end in 2011 resulted in deteriorating

terms of trade and a reversal of these surpluses into deficits.

Europe, Middle East and Africa (EMEA) economies vary

considerably in terms of their external sensitivity. Some of the

more commodity-driven economies, notably Russia and Middle

Eastern oil exporters, have seen substantial swings in their current

accounts which goes some way towards explaining the

characteristics of their fiscal and borrowing strategies.

PUBLIC DEBT LEVELS IN EM REMAIN SIGNIFICANTLY BELOW THAT FOR DM ALTHOUGH THEY ARE ON A RISING TRAJECTORY

Having been below 40% just eight years ago, EM government debt

is now approaching 50% of GDP. Although there is considerable

variance across EM, countries such as Brazil and Argentina have

experienced significant rises in government debt levels in recent

years. Despite this, EM public debt remains markedly below the

108% level of advanced economies.

To get a more holistic view of EM’s debt picture, perhaps a better

measure to look at is total debt-to-GDP, which includes

government, corporate and household debt. Similar to

government debt, total debt is considerably higher in DM (380% of

GDP) than EM (216% of GDP). There are signs that this gap is

narrowing however (Figure 6). In addition to generally rising EM

government debt, this narrowing is being driven by China where

total debt now exceeds 300% of GDP.

Figure 6: Total debt as % GDP for EM and DM6

EM DM

30

60

90

120

150

180

201120041997

400

350

300

250

200

150

1002018

%

6 Source: IIF, Insight, August 2019.

EM DEBT AS AN ASSET CLASS HAS SEEN DRAMATIC GROWTH

The EM debt asset class has experienced considerable growth

over the past two decades (Figure 7). Back in 2000, EM debt

represented just 2% of the global bond universe whereas today it

is closer to 25%. Yet despite today being such a significant part of

the global outstanding debt stock, EM debt remains considerably

underrepresented in global bond indices with of a weighting of

just 7% in the Bloomberg Barclays Global Aggregate Bond Index,

for example. This misalignment is in the process of being

remedied, with China’s accession to a number of global bond

indices.

MARKET STRUCTURE

EM DEBT HAS EXPERIENCED DRAMATIC GROWTH OVER THE PAST TWO DECADES, IN LINE WITH EM’S GROWING

ECONOMIC CLOUT. AS THE MARKET FURTHER MATURES AND BANK DISINTERMEDIATION TRENDS BECOME

FURTHER ENTRENCHED, WE EXPECT THIS TO CONTINUE.

Figure 7: EM debt as an asset class has seen dramatic growth over the past two decades7

0

4000

8000

12000

16000

20000

n EM local corporatesn EM local sovereignsn EM external sovereignsn EM external corporates

20182017201620152014201320122011201020092008200720062005200420032002

$bn

7 Source: JPMorgan, Insight, December 2018.

Back in 2000, EM debt represented just 2% of the global bond universe

whereas today it is closer to 25%

INCREASING BANK DISINTERMEDIATION SHOULD DRIVE FURTHER EM DEBT GROWTH

Bank lending remains the dominant source of financing in EM, in

contrast to DM where greater levels of financial disintermediation

have resulted in considerably more non-bank debt (Figure 8).

While this is largely a function of the greater maturity and depth of

DM capital markets, it is also just a manifestation of the post-global

financial crisis reality, where tighter bank regulation and increased

capital charges have forced a transfer of balance sheet lending

from banks to asset managers.

Longer term, EM should see the trend towards greater bank

disintermediation. The hard currency EM corporate debt market

serves as a good example of how this is already evolving. Just a

couple of decades ago this market was virtually non-existent with

corporates relying predominantly on bank lending. Since the

crisis, EM corporate debt has become very much a standalone

asset class. It has quadrupled in size, and at US$2.3trn now stands

at twice the size of both the EM hard currency sovereign debt and

US high yield markets (Figure 9).

8 Source: Bank for International Settlements. 9 Source: JPMorgan, Insight. 10 Source: IMF.

A CLOSER LOOK AT THE EM CORPORATE DEBT MARKET

This growth has also occurred at a time when the fundamental

quality of EM corporate debt is improving, while EM sovereign

debt’s fundamentals have marginally deteriorated (owing to

downgrades of Brazil and Turkey). The average rating for EM

sovereign debt is high yield, at BB+, whereas the average rating

for EM corporate debt is investment grade at BBB-.

In addition to enjoying a higher average credit rating, EM

corporate debt also serves as a useful diversifier. Using the

JPMorgan CEMBI Index as a proxy for the investment universe, EM

corporate debt encompasses over 60 countries across 12 sectors.

Furthermore, the ownership profile of EM corporate debt varies

quite considerably by region which contributes to lower cross-

regional correlations. Local investors tend to feature more

prominently in Middle Eastern and Asian markets, while offshore

fund investors tend to be more prominent in Latin America and

Emerging Europe (Figure 10).

Figure 10: Holders of hard currency corporate debt, by type (%)10

n Asian banks n Asian nonbank investors n US funds n European funds n Latin American investors n Middle East investorsn EM dedicated funds n Unidentified

0

20

40

60

80

100

EM Asia Latin America EM Europe MENA

Figure 8: Bank lending as a % of GDP8

Developed marketsEmerging markets China

0

30

60

90

120

150

180 China

Emerging Markets

United States

Advanced Economies

Jun18Jun 16Jun 14Jun 12Jun 10Jun 08Jun 06Jun 04Jun 02

%

US

Figure 9: EM corporate external bond stock (USD bn)9

0

500

1000

1500

2000

2500

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

n Investment grade n High yield

EM LOCAL DEBT (UNHEDGED) CAN PERIODICALLY GENERATE THE STRONGEST RETURNS BUT WITH GREATER VOLATILITY, MAKING IT LESS ATTRACTIVE STRUCTURALLY

EM debt risk-adjusted returns have traditionally been most

attractive in hard currency (Figure 11). While EM local currency

debt (unhedged) can, at times, generate some of the strongest

outright returns, it can also be the most volatile sub-asset class

leading to a low Sharpe ratio. Decomposing local currency

returns between spot FX performance and bond performance

(rates and carry) shows that FX has been the most volatile

component of returns, and has been a consistent source of

negative return in most of the asset class’ down years.

Given this, the structural rationale of investing in EM economies

as they improve over time has less relevance for this segment of

the asset class, although it potentially offers compelling tactical

opportunities.

MARKET BEHAVIOUR

EM DEBT RISK/RETURN METRICS VARY CONSIDERABLY ACROSS SUB-ASSET CLASSES AND REGIONS. INCOME

HAS, HOWEVER, BEEN A DOMINANT SOURCE OF RETURN OVER THE LONG TERM.

Figure 11: Return to volatility ratios (starts 2010)11

0.0

0.5

1.0

1.5

2.0

2.5

3.0

S&P

500

EM E

quity

US

Trea

sury

EM L

ocal

Cur

renc

y

EM S

over

eign

s

EM

Cor

pora

te IG

EM C

orpo

rate

HY

EM C

orpo

rate

s

10 Source: Insight, August 2019.

INCOME HAS DOMINATED RETURNS OVER THE LONG TERM

Income has tended to be large driver of returns over time for the

three EM debt sub-asset classes, while spread and interest rate

duration volatility dominate returns over shorter periods. Spread

and interest rate duration return contributions have tended to be

more amplified for hard currency sovereign debt owing to its

longer duration profile (c. 7 years) versus hard currency corporate

debt (c. 5 years).

KEY FACTORS AFFECTING EM ASSETS

EM – DM growth differential

Expectations of EM growth relative to DM typically drive asset

allocation (and returns) across all segments of the asset class.

Historically, EM assets have tended to outperform DM assets

when this growth differential is favourable. Higher growth rates

contribute towards an improvement in EM corporate and

sovereign fundamentals, which in turn attracts capital inflows and

supports asset prices.

The US dollar and US interest rates have important implications for the asset class

Whenever the Federal Reserve raises interest rates the effects are

often keenly felt in emerging markets. Higher US yields reduce the

relative attractiveness of EM assets prompting capital outflows

and depreciating EM currencies. For EM economies reliant on

external financing for government budgets or current account

deficits these outflows are most problematic.

Higher US interest rates and the stronger US dollar that typically

accompanies it do not usually bode well for EM local currency

debt, with underperformance primarily on the currency side

(weakening EM currencies). Furthermore, EM central banks might

be compelled to hike domestic interest rates to limit capital

outflow pressures, raising bond yields in the process.

A stronger dollar also has implications for hard currency EM

assets. EM corporates and banks that have borrowed in US dollars

yet whose revenue streams or assets are primarily local currency

denominated, may find it harder to pay off their hard currency

debt as EM currencies weaken. This can have negative

implications for their credit metrics and ultimately their credit

spreads. For EM local currency debt issuers, this problem does

not arise since it’s the investor in the debt that ultimately bears the

currency risks.

An evolving domestic investor base

The growth of domestic EM investors has changed the dynamics

of EM debt investing. The reorientation towards a more domestic

buyer base has been driven in part by memories of the 1990s

balance of payments crises where adverse currency moves had a

negative feedback loop on hard currency debt stocks. EM

countries want to avoid this ‘original sin’ problem by funding

themselves domestically, thereby removing currency mismatch

risks and reducing their reliance on foreign investor flows. It has

also been driven by the ongoing deepening and maturing of

domestic financial systems, with the growth of domestic pension

funds, asset managers and banks which provide demand for local

currency debt. This development brings reduced volatility as local

capital tends to be considerably more stable than foreign capital.

CONCLUSIONS

The shift in the world’s economic centre of gravity towards

emerging markets has been ongoing for much of the past three

decades. Emerging market economies now account for close to

half of global economic and trade output. While the size of the

EM debt asset class has tended to lag EM’s economic

importance, this is in the process of changing. Despite being

just a small speck in the global debt landscape twenty years

ago, today EM debt accounts for 25% of global debt

outstanding. As EM debt’s index representation increases

further and bank disintermediation trends start to catch up with

developed markets, we expect rapid growth in the asset class

to continue.

While EM debt returns have traditionally been most attractive in

hard currency, EM local currency debt (unhedged) has, at times,

generated some of the strongest outright returns. That said, EM

local currency debt also tends to be the most volatile sub-asset

class leading to a low Sharpe ratio, making this segment of the

asset class less attractive structurally. Income has tended to be

a large driver of long-term EM debt returns, while spread and

interest rate duration volatility dominate returns over shorter

periods. Among the key factors affecting EM debt performance

are expectations of the emerging market versus developed

marked growth differential, US interest rates and the US dollar

as well as developments in the domestic EM investor base.

IMPORTANT INFORMATION

RISK DISCLOSURESPast performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.

The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.

Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.

Portfolio holdings are subject to change, for information only and are not investment recommendations.

ASSOCIATED INVESTMENT RISKSFixed Income

Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.

A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.

The issuer of a debt security may not pay income or repay capital to the bondholder when due.

Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.

Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.

Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.

Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.

The investment manager may invest in instruments which can be difficult to sell when markets are stressed.

Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.

CONTRIBUTORS

Colm McDonagh, Head of Emerging Market Fixed Income, Insight Investment

Michael Warner, Analyst, Insight Investment

Cynthia Mar, Sovereign Analyst, Emerging Markets, Fixed Income Insight Investment

Derek Traynor, CFA, Senior Investment Content Specialist, Insight Investment

14674-08-19

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