Matthew Ryan of MFS Investment Management looks at how emerging market debt has evolved to better withstand market fluctuations
Emerging markets debt has been “rebranded” and “re-priced” in recent years. No longer just a high beta, high volatility asset class, EM debt has evolved into a more stable source of superior returns. This is a far cry from the roller coaster ride of volatility experienced during the crisis-prone 1990’s. The last decade has seen improving economic fundamentals underpin an enviable record of solid returns and reduced volatility.
For the skeptics, the global financial crisis of 2007-2009 was to be the “mother of all” stress tests. Emerging markets passed the test with flying colors. Entering the crisis with better average credit metrics than the major developed countries, EM countries exited the crises even stronger on a relative basis. As a result, we view the asset class increasingly as an alpha story, one that could outperform over both bull and bear market cycles.
How were emerging markets able to pass the “stress test”? Essentially by learning from past mistakes. The emerging markets crises of the 1990’s were cathartic. Policymakers recognised the need for more stable macro conditions and market friendly reforms. This meant reducing public sector indebtedness, freeing-up exchange rates, building foreign exchange reserves, reining in inflation and improving banking systems.
It also meant deregulation, privatisation, and a reduction in the state’s role in the economy. Building a solid macroeconomic foundation for growth and allowing the private sector to exploit this more business friendly landscape paved the way for world class companies to take root. It also provided an antidote to the boom-bust patterns of past government dominated cycles. Allowing the private sector to become the engine of growth has provided the path to sustainable growth in activity, investment and income.
In the case of emerging markets debt, the broad rally in risk assets from 2002 to 2007 was not simply a cyclical phenomenon built on leverage and unsustainable policies (as it was in some developed markets). Rather it was built on structural reforms and – in many cases – public sector deleveraging.
The road ahead
How will the story play out going forward? First of all, we believe emerging market economies to create and account for a growing share of the global economy. Second, we think these economies may see a healthy transition from export-led growth to greater domestic demand, characterised by higher household consumption and more public and private investment. Instead of funding developed country deficits, more emerging market savings will be directed toward new infrastructure and opportunities in their own economies. More broadly, we see this evolution in emerging market growth patterns as part of the global adjustment process and a necessary counterpoint to the balance sheet repair and lower demand that will ensue in developed country economies over the medium-term.
Recent worries about sovereign risk and the increasingly unsustainable debt dynamics of Greece, Ireland, Portugal, Spain, UK, US, Japan, and other developed markets only underscore the “policy decoupling” of emerging markets from developed markets. While sovereign balance sheets of developed nations have deteriorated in the wake of massive fiscal rescue packages, those of emerging market nations have seen only modest weakening (and generally from a much sounder base). This balance sheet divergence will contribute further to the GDP growth differential between emerging and developed economies.
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