Emerging market equities are now more attractive than the debt of these nations, prompting a change of strategy at Robeco Asset Allocation. Debt values in emerging markets had a rough year in 2013, hurt in particular by currency devaluations, but the worst now seems to be over for stocks from these markets, says Lukas Daalder, Portfolio Manager Global Allocations.
And as the debt sector may get worse this year, due to a raft of economic problems in these countries, Daalder believes the time is right to take action. The Robeco Asset Allocation team is selling emerging market debt to make the sector ‘underweight’ in its portfolio and buying emerging equities to increase its allocation to ‘overweight’.
The team manages more than EUR 20 billion of assets in multi-asset portfolios for institutional and retail clients from its office in Rotterdam.
“Emerging market debt posted one of the weakest performances of the various fixed income asset styles last year, as well as the worst full-year result on record,” says Daalder. “Yields rose, currencies weakened and returns disappointed.” The wide devaluation of emerging market currencies has been a particular problem because it cuts returns when the bond values are translated into euros for the fund.
Three reasons why emerging debt will underperform
Daalder and his colleagues believe there are three reasons why emerging market debt will continue to underperform, due to economic factors, devaluing currencies, and the relative volatility of the sector against others.
- Economic factors: growth is still weak in emerging markets. China has problems with the structural rebalancing of its high-growth economy, while lower commodity prices will reduce revenue for those nations reliant on natural resource sales. Meanwhile, stubbornly high inflation is persisting in some countries, particularly Indonesia and Brazil.
- Currency problems: “We in general expect the downward pressure on emerging currencies to continue for now,” says Daalder. “Weaker economic fundamentals and higher current account deficits mean emerging market countries may allow their currencies to weaken even further as this will help their export sectors.”
- High volatility: “Investors who had entered the market expecting stable and predictable bond-like returns found out the hard way that due to the currency component, emerging market debt volatility lies markedly above volatility for the high yield sector,” Daalder says. “Emerging market debt does not yet price in a sufficient risk premium for this unwanted volatility, so we have now decided to cut emerging debt to underweight.”
Volatility: high yield offers a better risk premium. Source: Bloomberg
In the multi-asset arena, the key question for the team is which asset is preferable if you start selling emerging debt, and another form of fixed income was briefly considered. “Within our tactical asset allocation methodology, we compare emerging market debt with high yield, which make sense as they are both fixed income categories,” says Daalder.
“However, given that we are already quite overweight in high yield, and given the relative illiquid nature of this asset class, we are hesitant to increase our position further. Instead, we prefer to switch from emerging market debt to equities.” So the money raised from selling emerging debt will be spent on equities, he says.
Three reasons for preferring emerging stocks
Indeed, there are three reasons to switch into emerging market stock markets, due to more favorable currency factors, the fact that equities are quite cheap, and better exposure to any improving outlook, says Daalder.
- Currency factors: “Equities are to some extent hedged for a decline in currencies, in the sense that a weaker exchange rate boosts the earnings outlook for export-oriented companies,” says Daalder. “The case of Japan is a clear example: the weaker yen has had a high correlation with earnings, as well as the performance of the Nikkei.”
- Inexpensive values: “Whereas we think there is no sufficient premium in emerging market debt, stocks from these regions are currently cheap compared to the pricing seen in developed markets. In other words, risks are better aligned with potential rewards,” he says.
- Improving outlook: “If the emerging market outlook does improve (contrary to what we currently believe), we expect to see a better return in equities than in bonds,” says Daalder. Given the difference of the composition of the Emerging Equity benchmark (with much bigger weights for Taiwan and Korea), Daalder also expects this turnaround to materialize earlier in equities than in bonds.