Research & Insight

After starting 2011 with weak performance in January, emerging markets debt bounced back, finishing the quarter up over 3% in US dollar terms. Strong growth, high commodity prices and easy monetary policy in the US and Eurozone have led to strong investor demand for emerging markets assets. The quarter has been notable for some very big global events such as the ongoing political conflict in the Middle East and North Africa, as well as the Japanese earthquake and subsequent tsunami. While these have had only an indirect effect on local currency emerging markets debt, mainly through the spike in the oil price, they have contributed to a rise in market volatility.

Despite the continuing protests in the Middle East and North Africa (MENA), local emerging market bonds remained firm over February. The JP Morgan GBI-EM Global Diversified index returned 1.49% in US dollar unhedged terms. It would have been very difficult to imagine beforehand the extent and pace of change we have witnessed in North Africa and the outcome of the protest is clearly very hard to predict. Rexiter is watching the situation very closely due to the effect and sensitivities this has on the wider emerging markets universe, and in particular commodities pricing. Remarkably all regional returns remained positive over the month, even MENA. Given the extent of the protests, change and uncertainty for Egypt, we think it would be no surprise to our readers that the return from Egypt was negative over the month. However, Egypt fell only 4.7% in February, which we think is light given the extent of the circumstances. Emerging market investors will be pleased that they were more than compensated from returns in commodity producing countries, such as Russia.

It will come as no surprise that the singularly most common question we have been asked over the past six weeks is the effect of the Middle East and North Africa (MENA) crisis on local currency emerging market debt prices. The good news for local currency emerging market debt investors is that Egypt aside, which has a less than 0.5% representation in our benchmark, the current participants in this crisis are outside of the investable universe. Further, we anticipate that it is extremely unlikely that political unrest will spread to countries within our universe.

One theme that is very clear from global economic trends is that the monetary policies of the advanced and emerging market (EM) economies will diverge even more in the coming year. All three major developed central banks (BoJ, ECB, and the Fed) remain focused on their ongoing easing programs, and even if upside economic risks materialize, an early exit is unlikely. On the other hand, EM central banks have thus far stayed away from hiking policy rates aggressively because of the need to balance weak external demand with strong domestic demand, inflation concerns that have not yet appeared in core measures, and the impact that rate hikes could have on currency strength. Given the upside risk to growth in many parts of the world and higher inflation risks this year, EM central banks are likely to take away more of the monetary easing that is still in place.

To assess the value of an allocation to emerging markets local currency bonds in a multi asset portfolio we need to consider two factors:

1. The degree of diversification achievable – based on the correlation of returns with those of the existing portfolio / asset class.

2. The effect on the total portfolio risk / return profile – measured by the change the in expected risk adjusted returns of the combined portfolio.