Opportunity in emerging-markets credit
America appears to be winning the trade war — at least according to the markets. US stocks have just experienced one of the best stretches compared to non-US stock markets in quite some time.
Based upon rolling three-month investment returns, the recent level of outperformance measures an impressive two standard deviations above the norm, or an event which historically happens only about two per cent of the time. Statistically speaking, one should expect such strong relative outperformance to happen only once every 12˝ years.
While the US market has recently hit a new all-time high, the ongoing trade war has kept more globally positioned investors on edge. Export-driven economies have been hit especially hard. Common knowledge tells us that no one wins a trade war, however, those countries which can endure the most pain tend to suffer the least.
In this case, the US seems to be succeeding on a relative basis and this makes sense in light of America’s highly versatile and well-diversified economy. Plus, the US is riding high on the tail wind of a massive corporate tax cut.
Year-to-date, emerging market economies such as China and its satellites have suffered negative returns in their local markets while their currencies have also been hammered. The MSCI emerging markets stock index is down 12.7 per cent compared to an increase of 7.6 per cent for the S&P 500, representing underperformance of almost 20 per cent!
Clearly, Trump’s trade war has increased the risk of investing in smaller and less developed markets just as higher US interest rates are steadily enticing capital away from these economies. On top of the trade concerns, country-specific political turmoil in nations as far apart as Turkey and Argentina have not helped. Meanwhile, Europe has its own challenges dealing with its decelerating economic growth, Italy’s credit bubble and the nettlesome Brexit negotiations.
While many of the non-US equities markets have been roiled by the trade war, fixed-income markets have also been affected. Eight years into one of the longest economic expansions in US history, credit spreads have tightened substantially. Corporate credit spreads, a measure of investor risk appetite, have generally ground tighter over the past several years. Other credit products, including asset-backed securities and high-yield bonds are also plumbing historically tight levels.
US dollar investment grade credit spreads, as measured by the JPMorgan Global Aggregate Investment Grade Credit Spread Index, have tightened from an average of 1.64 per cent over the past ten years and 1.35 per cent over the past five years, to a current average spread of just 1.29 per cent. Interestingly, investors have become relatively complacent about credit risk just as non-financial companies have taken on historically high debt levels.
For example, over the past ten years the percentage of BBB or lower rated investment grade credit, has risen from 35 per cent to 49 per cent of the total outstanding amount.
Bucking the trend has been emerging-market debt where bonds are now offering higher yields while spreads are trading at wider levels than they have in the past. The JPMorgan Emerging Markets Bond Index for US dollar-denominated debt shows the current aggregate spread at 3.88 per cent, compared to a ten-year average spread of 3.68 per cent and five-year average spread of 3.64 per cent.
Wider credit spreads would seem to indicate higher risk. However, in contrast to the US-domiciled debt markets, EM credit quality has been on the upswing. Over the past ten years, the amount of investment grade-rated debt as a percentage of the total has increased from about 40 per cent to 59 per cent currently. Twenty years ago, only about 10 per cent of EM debt was rated investment grade.
While emerging markets clearly have had their ups and downs over the past two decades, the longer-term trend seems to be towards further progress, particularly for those economies which can adapt to shifting geopolitics. In the meantime, carefully selected EM credit issues look like a good bet for fixed-income portfolios.
• Bryan Dooley, CFA, is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority