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A Bubble in Emerging Market Debt?

Emerging market debt has been a fantastic investment over the past five years, but what should we expect in the next five years?

Jose Garcia-Zarate 12 September, 2012 | 7:00AM

Emerging market debt has been one of the best performing assets during the last five years. Many investors are running scared from troubled developed markets where default risk is rising and they’re also tired of ultra-low yields offered by the likes of the US, Germany and the UK. Therefore, these investors have found an oasis of sorts in emerging market debt. The combination of improved credit quality, yield pick-up and the potential to enhance returns via currency plays has proved too tempting to ignore. As a result, active and passive funds offering exposure to emerging market debt now routinely make up a large portion of “Top 10” lists. However, as the first solid signs of trouble in emerging market economies arise (e.g. China slowdown), it is perhaps wise to question whether it makes sense to continue betting on stellar performance from emerging market debt going forward.

To assert that we are on the cusp of a market bubble is perhaps too controversial. However, what seems pretty clear is that current emerging market debt market valuations tell the tale of a crowded trade

The strength of money flows into this asset class over the last few years has pushed yields to levels which are not only low on a historical basis, but perhaps also indicative of miscalculation of risk. To assert that we are on the cusp of a market bubble is perhaps too controversial. However, what seems pretty clear is that current emerging market debt market valuations tell the tale of a crowded trade. Rationally this means that investors considering emerging market debt at present are unlikely to enjoy the same level of high returns in the future while possibly taking on an unsuitably high level of risk relative to their personal circumstances.

The weakening of economic growth in emerging market economies so far into 2012 has come to challenge the notion of a virtuous decoupling from the ills of their developed counterparts. This could have a negative impact on emerging market debt valuations going forward.

A significant proportion of the money flows directed towards emerging market assets over the last few years has been predicated on the assumption that these economies had already reached a stage where internal demand was structurally strong enough to take over the role of key growth engine. We are now seeing that this was not a solid proposition. Take the case of China, which is increasingly becoming the subject of articles and analysis highlighting the perils of overestimating the capacity of domestic consumption to absorb the product of a manic investment drive in housing and infrastructure.  

As the shortcomings of the “internal sources of growth” policies become ever more apparent, emerging market governments could turn all their efforts once again towards maximising exports to developed markets. In the current global macroeconomic scenario where demand from developed countries is scarce, such a strategy may call for aggressive emerging market currency depreciation. The risk for investors in local currency-denominated emerging market debt – a segment of the debt market that has experienced significant growth in the past few years – would be obvious, with the benefits of yield pick-up offset by increasingly unfavourable foreign exchange considerations.   

Emerging market assets have become a mainstream investment. They have certainly provided good returns over the past few years. However, the maxim “past performance is no guarantee of future results” still applies. As always when investing, it is key to weigh up the risks against the expected rewards, particularly when the party has been going for such a long time. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Jose Garcia-Zarate

Jose Garcia-Zarate  is a senior ETF analyst with Morningstar Europe.