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Emerging Market Debt

 
 
 
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Emerging Market Debt Q&A, September 2010

 
Brett Diment

Brett Diment, Head of Emerging Markets Debt

Brett Diment, Head of Emerging Markets Debt at Aberdeen, discusses Aberdeen’s approach to investing in the asset class. He looks at the compelling outlook for emerging markets and believes that the asset class will produce solid returns over a three to five year period based on improving fundamentals and rising growth expectations.

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After strong returns in 2009, performance of emerging markets debt has been positive but not as strong. Are you still seeing opportunities?

Performance has been good in 2010, but there has been more country differentiation with asset selection being a key driver of performance. Local currency bonds have performed well as growth has moderated and we expect this trend to continue. In addition the weaker than expected growth in developed markets has been positive for emerging markets as the heat has been taken out of commodity markets and the Federal Reserve in the U.S. will need to keep rates on hold for longer, which are positive factors for the asset class.

Finally, we have been active in the corporate bond market, with new issuance continuing to broaden the opportunity set.

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Growth has moderated in emerging markets. Are you still as positive on the long-term outlook for emerging markets and the asset class?

Growth has moderated as firms have re-built their inventories. We see this as a positive factor for the asset class however, as it means there is less pressure on central banks to increase interest rates, less upward pressure on inflation and a move back towards trend growth. Our view on the long-term prospects remain unchanged - emerging markets are supported by solid fundamentals and better demographics than their developed market counterparts.

Additionally, emerging markets are generally more self sufficient and not as dependent on exports to the developed world as they were in the past. As a result, we expect these economies to continue to grow and for the asset class to continue performing well.

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Inflation has recently picked-up in some emerging market countries despite moderating growth - is this a risk for the asset class?

The recent up-tick in inflation is indeed a risk. Rising food and energy prices as well as rising home prices are contributing to this rise in inflation, particularly in Latin America and Asia, which could be a setback for some local rate markets. The risk is not immediate however and we are not overly concerned at the present time. However we will continue to monitor the rise in inflation and central bank action in response to this.

Signs of growth moderation

Latin America May export orders pick up due to Mexico EMEA May export orders pick up, partly offsetting weak domestic orders Non-Japan Asia ex-China

Source: Haver Analytics, Statistics office, PMI Premium, July 2010

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In light of these possible inflationary pressures, do you expect central banks to tighten and if so what will the effects be?

Despite inflationary pressures, the outlook for emerging markets debt remains positive as softening global growth and low core market rates continue to be supportive for the asset class. Positive market technicals are another driving factor, with inflows showing no signs of abating. We expect central banks, particularly in Latin America and Asia, to continue on a path of policy normalization in the coming months. As such we expect the asset class to continue to do well while the outlook for the region remains positive.

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What areas of emerging markets do you find interesting at the moment?

Investment decisions are much more dependent on individual country specific issues rather than the indiscriminate recovery we saw last year. As a result diversification in our portfolios has increased. Areas we currently like are Brazil, where the local currency 10-year bond is yielding around 12%. We also like index linked bonds in Uruguay with the 10-year bond yielding over 10% when adjusted for inflation. We also have exposure to the Middle East in the United Arab Emirates, Qatar and Bahrain and we also like South African local currency bonds which are good value.

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Conversely, are there any areas you would avoid in the current environment and why?

We are underweight BBB rated sovereigns such as Brazil and Peru, where we see little value in the U.S. dollar bonds. We are also underweight BB rated sovereigns, with Colombia, Turkey and the Philippines also trading at excessively tight spreads.

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Can you give an example of a country you like and tell us why you like it?

Indonesia appears to be one of the few emerging market sovereigns poised for upgrades, reflecting a healthy fiscal position, and a broad based recovery. In our view, we think Indonesia could make the leap to investment grade over the next two years, as it is currently rated just two notches below investment grade by two of the rating agencies.

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I already gain exposure to emerging markets via equities why should I invest in emerging markets debt?

Aside from the opportunities available in equity markets, there are some quite large bond markets in emerging markets that are by no means fully developed but that are maturing. Returns have been attractive, volatilities low and diversification benefits substantial.

On the credit side, debt markets have grown substantially, with governments issuing longer dated issues and thereby creating a reference yield curve that to date had been lacking in many markets. Both dollar bond and local currency issuance has picked up, and this of course reflects the improving credit worthiness of sovereigns (and corporates) as well as relatively low global interest rates - that have reduced the costs of issuance. Just as with equities, it is important to diversify your fixed income portfolio.

Indonesia: climbing to investment grade

Anchoring inflation expectations is key to IDR risk premium Positive fundamentals supporting the currency remain intact

Source: CEIC, GS Global ECS Research, Aug 2010

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What do you feel is the benefit of investing in emerging markets local currency debt?

Emerging markets local currency debt has explicit exposure to currency and interest rate dynamics and the investor base is dominated by local institutional investors. The asset class offers broad geographical diversification as well as being a natural hedge against U.S. dollar weakness. It also offers the potential for currency appreciation and diversification for hard currency emerging market debt portfolios. Local currency debt is a relatively new asset class and mispricing inefficiencies exist. As active managers, we can take advantage of opportunities in this area and we are very positive on this asset class.

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When do you think is a good time to invest?

Over a three to five year period, we think investors will enjoy good, solid returns from an asset class that is clearly benefiting from a combination of improving fundamentals and rising growth expectations. As a result we believe any time is a good time to invest in this attractive asset class.

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What experience do you have in emerging markets debt?

We have considerable experience in emerging markets debt with over 70 years combined investment experience. Members of the team have been researching the asset class since 1993. The depth of our experience enhances our ability to interpret ongoing country developments and also allows us to make rapid decisions and implement trades quickly.

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What is your process for investing in emerging markets debt?

We focus on the entire emerging market debt universe to maximize the alpha potential of our funds. We conduct comprehensive country research, set in the context of global economic developments, which forms the foundation of our investment process. We look at factors such as key macroeconomic variables, the political environment, fiscal and monetary policy developments and major risk. This is coupled with analysis of market technicals such as the nature of instruments, relative value, liquidity and demand and supply imbalances.

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How many countries do you research for this product?

We research over 40 countries and our team conducts over 100 meetings annually with senior policy makers. We also meet with local corporates and banks, as well as local investors, independent economists and political analysts. This allows us to better gauge developments within each country.

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What importance do you place in the benchmark?

We are aware of the benchmark but that does not drive our investment decisions. We are comfortable taking positions outside the benchmark and actively do so where we see opportunities. Our own research is key to our investment decisions, therefore we are not constrained by what is in the benchmark. We are cognizant of the benchmark however, in that we monitor any significant deviations to ensure that we control beta risk in our portfolios.

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What do you see as your key competitive advantage?

I believe our key competitive advantage is that we are an independent team and we carry out our own research which drives our investment decision making process. We do not follow consensus or the benchmark when we invest as we believe our process will deliver the optimal portfolio and attractive returns for our investors.

Being unconstrained by a benchmark also allows us to add value wherever we see it across the entire emerging markets universe. In addition to this we have an experienced team, a strong global resource and a tried and tested investment process which I believe puts us at an advantage over our competitor.

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