Bonds beat equities in emerging markets

Believe it or not, emerging market bonds have outperformed emerging market equities over the past two decades.

Over the first 20 years of the millennium, the average emerging market bond fund has returned some 479.57%, compared with 323.44% for the average emerging market equity fund (and 155.33% for the average UK All companies fund)*.

That’s some feat, but the universe of available investments has also made huge headways over that period.

According to Claudia Calich, manager of M&G Emerging Markets Bond fund, the asset class is much more diversified than it was in the early 2000s. “There are almost 80 countries represented now, while there were fewer than 20 then,” Claudia said. “Many countries, Brazil included, also managed to improve their debt profiles by funding more in their local currency instead of via external debt. This increased resilience and has helped to lower contagion risk.”

2019 proved to be great year for returns in most asset classes and emerging market debt was no exception. The asset class outperformed global bonds by some 3.75%-5%*. But what does 2020 hold in store?

Outlook for 2020

The risks for emerging market bonds are numerous – as they were last year, according to the team at M&G. Firstly, there are geopolitical tensions in the Persian Golf. Iran has elections next month in a context of a sharp economic recession (the IMF predicts -9.5% GDP growth in 2020). “Elections could well revive tensions this year and escalation in the Middle-East could have a significant impact on asset prices in the region,” commented Charles De Quinsonas. “Another source of concern is Iraq, where public discontent is growing quickly on the back of government corruption allegation, while in Asia, North Korea may undertake new missile testing and Malaysia recently joined Vietnam and the Philippines in their tough stance against China’s claim that the whole South China Sea belongs to China. The US election is another key geopolitical risk this year.”

Secondly, one of the biggest risks for emerging markets whose economies continue to rely extensively on global trade is the ongoing US-China trade war. “Some Asian economies are now seeing falling supply-chain related exports due to the decline in China exports to the US, “ continued Charles. “However, other developing countries have emerged as winners. Vietnam, Mexico, Malaysia and Thailand all have benefited from either a direct rise in exports due to diverted US demand from China and/or an indirect rise in exports related to the supply chain of China’s competitors.”

“The stellar returns produced in 2019 are unlikely to be replicated in 2020,” concludes Claudia Calich. “This is mainly since starting valuations are less favourable than those which we had a year ago. I remain neutral overall in terms of asset allocation given the uncertainty of the various geopolitical risks and potential impact on the US dollar.

“However, while emerging market debt may not look cheap when compared to prevailing valuations a year ago, most other asset classes have also rallied materially. So on a relative basis, maintaining exposure to the asset class may still look like an attractive proposition for its income in an environment of still low yielding assets elsewhere.”

First State Investments believes emerging markets appear to be in reasonable shape for 2020. “Growth differentials between emerging and developed markets are expected to increase again after shrinking slightly in 2019, which should result in improved capital flows towards emerging markets. Lower sovereign bond issuance should also reinforce the market from a technical perspective,” the company said.

“Countries in the Middle East and Latin America are likely to see a particularly strong growth impulse. Sentiment towards Latin America as a whole has been eroded by recent economic challenges in Argentina, as well as various other interruptions and protests against governments. But we believe countries like Mexico, Peru and Brazil can pick up the slack.

“The elephant giant panda in the room remains China, which continues to contribute much of the growth in the emerging market universe and greatly influences the prevailing business cycle. Averting the risk of further tariffs being introduced on goods exported to the US should help ease economic policy uncertainty and, in our view, result in a slightly stronger Chinese economy in the second half of the year.”

First State Investments agrees with M&G that investors might once again have to grapple with geopolitical issues during 2020. “There is a reasonable chance that North Korea resumes missile testing and, perhaps, even underground nuclear testing program. Moreover, recent rhetoric suggests the country has moved closer to both Russia and China. Investors must consider the potential consequences of this development, including how ensuing instability could affect fragile relations between the US and China.

“Overall, not withstanding some potential volatility along the way, expected returns of between 5% and 9% from the asset class in 2020 appear reasonable, but of course, this cannot be guaranteed.”

Other Elite Rated funds investing in emerging market debt:

In his podcast, just before Christmas, Bruce Stout, manager of Murray International Investment Trust, explained to us why he currently refers emerging market bonds over those from developed countries.

The trust can invest in the shares of companies from all over the world, and has the flexibility to invest in fixed income if the right opportunities arise. The trust currently has 14%** invested in emerging market and Asian fixed income, including South African, Indonesian, Mexican and Brazilian bonds**.

M&G Global Macro Bond has around 16%** in emerging market bonds – including those from Indonesia, Malaysia and Brazil, while Premier Multi-Asset Monthly Income fund has 4% invested in two emerging market funds**.

*Source: FE Analytics, total returns in sterling, 1 January 2000 to 1 January 2020.
**Source: Fund factsheets, 31 December 2019