Increased foreign exchange reserves and more sophisticated monetary policies have contributed to the improving fundamentals of emerging market countries.
These improving fundamentals as well as low financing needs provide emerging market countries more policy flexibility then developed markets, thus increasing their potential to continue growing at a faster rate.
The overall expected growth rates for emerging markets are much higher than for developed markets, 4.6% compared to only 1%. Given the current low interest rate environment, we continue to see the potential for investors increasing their strategic allocation to emerging market debt given the attractive yields and improving fundamentals.
Quality at the right price
While developed market ratings have steadily dropped since 2009, EM ratings have continued to rise. The relative change in credit ratings reflect the improving fundamentals of EM countries including stable debt levels, current account surpluses, controlled inflation, and tighter monetary policies. Such factors should allow for faster growth and therefore better market returns for investors.
In the recent environment where many European countries have been downgraded, the investment world witnessed a significant number of credit rating upgrades in emerging market sovereigns and corporates, including Brazil, Peru, and Panama. Emerging market sovereign upgrades should continue to exceed downgrades with an expected 22 upgrades in 2012.
Over 45 emerging market countries are now rated investment grade, equating to 57% of the universe. The aforementioned better credit quality that many EM sovereigns have been able to achieve has provided some comfort to investors. We have seen a notable increase in the demand for emerging market investment grade assets.
Expanding debt universe
The emerging market debt universe has continued to grow and widen its parameters. Inflows to dedicated EM fixed income funds are expected to remain stable at US$40 billion in 2012 supported by allocations from domestic pension funds and sovereign wealth funds.
Looking to recent events, we have seen a number of new issues – both sovereign and corporate come to the market and investor appetite has been high. Mexico for example, issued a US$2bn 10-year bond and enjoyed three times the orders it required.
In addition, South Africa received some double the orders for its US$1.5bn 12-year issue. As for the corporate world, almost 10 new bonds have been issued, raising more than US$9bn. One change from previous years is that the majority of new issuance in early 2012 came from investment grade issuers rather than high yield EM sovereign and corporate issuers, which supports our view for improving fundamentals in the asset class going forward.
Current valuations look attractive
Many emerging markets have high levels of international reserves and are net creditors. In response to the recent global financial tightening, the countries have been able to use these reserves to provide liquidity in foreign currency and have prevented their currencies from selling off and depreciating as had happened in the past.
The currencies we favour have clean technicals, offer attractive valuation, and have central banks who we anticipate will ultimately keep inflation under control. Given the return potential, we plan to use EM FX as a substitute for risky higher beta credits, such as Venezuela and Argentina, in 2012. The dim forecast for overall global economic growth should lead to a lower inflationary climate, which in turn should provide a boost to local bonds. Currently EM local debt yields offer more than 5% additional yield than the 5-year US Treasury.
EM hard currency debt also looks attractive going forward. During 2011, most external debt countries were concentrated within tight spread levels around Libor+100 to Libor+200. Due to market stress in the second half of last year, there is now meaningful differentiation among issuers of similar credit quality which will allow active managers to generate more alpha. Spreads for external and corporate debt have experienced meaningful compression in 2012 which we believe should contribute to strong total returns in 2012.