While emerging markets have witnessed some strong periods of market turbulence in 2018 against a shifting geopolitical backdrop, McDonagh believes some investors may be overstating the risk of some EM investment versus developed markets while underestimating their opportunity for attractive returns.
Speaking at the 2018 BNY Mellon Northern Investment Conference in Edinburgh he told delegates he believes looking at the investment universe of ‘non-G10’ defined fixed income markets offers a different way of thinking about what EM is. He added that these markets hold a wide range of opportunities which can, from a global bond investor’s perspective, offer attractive returns.
“When considering the emerging market asset class people tend to immediately associate it with higher risk investments while ignoring some of the higher quality on offer. While it is true some emerging markets, such as Argentina, have seen serious bouts of historic volatility, others, such as Azerbaijan, are underpinned by some strong fundamentals and we believe are worthy of some serious consideration.”
According to McDonagh a key mistake many investors make in EM is to enter the sector at the peak of the market and exit as it falls, repeating a destructive pattern over time.
“All too often, investors’ entry point into EM is too pro-cyclical, both in positive and negative environments. Perhaps more flexibility is required in their investment approach in terms of diversification and investment timing.”
Commenting on the specific appeal of EM fixed income, he added: “The attractions of EM debt are actually far more compelling than most people assume, given the spectrum of credit quality ranges from low to very high quality.
“We believe a number of markets are in pretty good shape and offer some attractive risk-adjusted returns. That said, caution is critical in other parts of the investment universe and investors should frequently question whether their investment approach matches their return and volatility appetite.”
Although many EMs lack the sophistication of developing markets, McDonagh queries the relevance of the ‘emerging market’ tag applied to some more sophisticated markets. “We are now at a stage where many aspects of the basic infrastructure of markets such as South Korea are now more advanced than in fully developed markets such as the US and much of Europe,” he said.
“Governance has been part of the evaluation process in EM, but is improving in many major market such as China. In contrast, people often forget the level of risk present in developed markets – as evidenced by the global financial crisis. This should remind us it is not just emerging markets that carry corporate and governance risk.”
From an investment standpoint, McDonagh cites currency as a key consideration when selecting emerging market fixed income investments. “While hard currency denominated debt can appear attractive, local currency denominated debt can often provide more flexibility – to issuers, if not investors – in periods of volatile markets.
“From a credit point of view it is far better for EM countries to issue debt in their own currency as it will allow them to better withstand any external market shocks.
“During the European sovereign debt crisis Greece – a member of the Eurozone – was not able to devalue its currency and subsequently faced far greater financial shocks than it would have done if it had more flexibility to make currency adjustments. If you borrow in a currency that is not your own it is easy to get into difficulties if markets turn.”
While McDonagh continues to see serious potential in EMs, he is concerned by the recent trade and economic stance adopted by the US Trump administration. McDonagh believes the US government’s actions may have unintended consequences and could even challenge the widespread global appeal of the US dollar – historically seen as a key global reserve currency.
“At the start of this year, EM growth was good, but geopolitics have now changed the market materially. The Trump administration seems to be trying to unwind huge amounts of post war international collaboration, whether through a review of World Trade Organisation membership, the IMF or specific multilateral trade agreements.
“Consequently, the US government is now using sanctions heavily to try and get governments to bend to its will. While this approach may get some result in the short term the consequences are that people start thinking about the US dollar and considering alternative currencies and the settlement systems they use. While the US has had a huge advantage in terms of the dollar being an important reserve currency, its government’s aggressive stance on trade could come back to haunt it,” McDonagh concluded.
The value of investments can fall. Investors may not get back the amount invested.