The Importance Of Being Earnest - FTSE

EMERGING MARKET DEBT: THE BEGINNINGS OF A BUBBLE?
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DEBT REPORT
structural change over the last ten
years, aligning the interests of local
issuers, the EM authorities, attempting
to build out their yield curves and
develop local markets so they don’t
have the problem of having too much
foreign denominated debt, and the
investors, attracted to the growth story
and the improving fundamentals and
high interest rates in the emerging
markets.” If anything, the financial
crisis has exacerbated flows from the
OECD since the debt to GDP ratio
“has gone up massively in developed
countries, leading to the current crises
in the peripheral EU countries”.
He adds: “Brazil has really been at the
forefront. Investors were worried when
[Luiz Inacio] Lula [da Silva] was elected,
but his measures reassured them. Brazil’s
bonds built the local yield curve. Another
success story is Mexico whose local
authorities are issuing paper for 20/30
years, which is liquid enough for
investors. Local pension funds dominate
here since in many ways local issuance
removes a risk factor, and it’s all about
minimizing liabilities, while for the
foreign investor there’s the chance for
currency appreciation as well as in the
capital gains in the market.”
Be wary of temptation
So what are the serpents in this EM
garden of Eden? Faergemann suggests
that investors need to be “more sophisticated,
balancing risks from interest
rates currency rates and duration risk;
they need experience and a specialist
approach to stay ahead of these rapidly
changing developments”. For example,
increasingly EM authorities have taken
steps to slow the pace of currency
markets to better manage the pace of
currency adjustment and investors
need to monitor that carefully.
What about the risk of a potential
bubble forming? Flaherty agrees: “Very
low interest rates in developed markets
are driving demand for higher yielding
assets, so there is a risk of bubbles
forming. However, we don’t believe
this is the case at present and the
increasing sophistication of domestic
Jack Flaherty, investment manager, fixed
income, GAM. Photograph kindly supplied by
GAM, April 2011.
emerging markets—often underpinned
by a growing local institutional investor
base—helps to offset this risk.”
Faergemann bases his EM optimism
not just on the relative yields but the
fundamentals of the EMs. “Domestic
consumption as well as investment is
rising while infrastructural investment in
developing markets brings investment,
inflows, changes to these economies.
It’s not just portfolio investment, but
very much FDI [sic] and this is why we
see this growth as sustainable.”
The other anti-bubble protection is
that most of these instruments are held
by local, less fungible, investors. Faergemann
explains: “The increase in
domestic issuance has mostly been led
by locals themselves so foreign participation
is still small. Some countries like
Mexico and Indonesia are up to 30%
foreign participation, but in the main the
growth is led by local institutions, such as
insurance companies and pension funds,
and this is crucial to understanding why
these markets are beneficial to both
investors and the local authorities. It
averts the currency mismatch and provides
stability to local markets and
funding for local governments, giving
them much more stable financial
markets. We aren’t creating a bubble
here. It goes to local investors. “ Part of
the new acceptability of EM investments
is indeed a willingness to treat each
country separately rather than lump
them together as Wall Street tended to
do last century. Flaherty explains: “While
many investors are benchmark driven
and might tolerate exposures that are
high in political and economic risk, GAM
uses a variety of tools, notably our proprietary
crisis filter, to help us identify
which countries are at greatest risk. All
three of our portfolio managers, who
have economics backgrounds, have
extensive experience and numerous contacts
in emerging markets that they can
draw on to help make investment decisions
and frequent country visits
supplement their research.”
So where is the clever money going
to go now? GAM’s Flaherty says: “The
local currency outlook is very important
to us, and is a key source of returns to
the asset class. We particularly like
Asian FX at the present time. In an
environment where inflation is still
increasing, where most are exposed to
high oil prices (the direct inflationary
consequences of which will be difficult
to address via rate hikes), it makes
sense to allow greater FX appreciation
to help fight inflation.”
Many of the investors are benchmarked,
and tend to align with the
indices which reflect market cap.
Faergemann points out: “We used to
invest more in frontier markets with
some success. But with the disinflation
process in EM, rates have come down;
G3 rates are at historical lows, so at
this juncture you need more yield for
the frontier market. We have seen
interest rates drop from the mid-20s to
low double digits, but that also means
that, for example, with Zambia’s oneyear
interest rates at 9.3%, it does not
take a lot of volatility in the currency to
take away your carry, so you need more
premium in frontier markets to compensate
for that risk.”
Equally, explains Faergemann, investing
in emerging markets is now a
long-term play. He says the expansion
of EM foreign investment “is going to
last for ten years based on the solid fundamentals
of their economies: low
unemployment in EM along with
strong credit expansion and the commodity
cycle will really benefit them”. ■
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