To asset managers, national economies are much like bicycles, buildings or human pyramids: Collapses and disasters can largely be blamed on imbalances.
Imbalances have been at the heart of a series of emerging-markets minicrises since mid-2013 — in this case, those in the current accounts of several countries. Turkey and South Africa, two nations that have gotten heavily caught in market turmoil, both have current-account deficits of about 7 percent of gross domestic product, mainly because imports greatly exceed exports. After the U.S. Federal Reserve signaled last year that it would taper quantitative easing, bit by bit, turning off the tap of U.S. dollars, investors began to wonder where economies would find sustained international capital inflows to fund their large cash outflows.
Debt specialists know, however, that national economies can put up with a fair degree of lopsidedness, as long as it is sustainable. When it comes to current accounts, emerging economies can live comfortably with moderate deficits, if supported by stable sources of funding and strong underlying economies. Mexico, for example, has a deficit of only 2 percent. Moreover, much of this proportion is financed by foreign direct investment — a much less flighty source of funding than purchases of stocks and bonds by international investors.
In our opinion at Aberdeen Asset Management, the country’s underlying economy is strong, and it is laying the foundation for still greater strength. Mexico’s labor reforms should sharpen the country’s competitiveness and put it in a position to compete with China on labor costs. In addition, Mexico is well situated to take advantage of opportunities from the U.S. and Canada to tap into the major global trend of near-shoring, by which multinationals place factories near their home markets to shorten the supply chain.
Brazil has also built a base for long-term economic growth by reducing income inequality and investing in its education system, measures that should boost GDP. These factors, and the country’s high level of foreign direct investment, suggest that Brazil’s deficit, at a little under 4 percent, is viable.
Many emerging-markets economies have current-account surpluses, rather than deficits. During the recent market turbulence, pundits have talked about the economies of the Fragile Five: Brazil, India, Indonesia, South Africa and Turkey, all of which are running current-account deficits.
But at the same time, one could equally well talk about the Formidable Five. These are emerging markets that are running surpluses: China, Malaysia, the Philippines, Vietnam and Nigeria, to name a few contenders. A common factor among these five countries — and many other emerging markets — is their age demographics. The growing tax base that will come from their young and growing populations should provide a strong foundation for sovereign bonds. In many cases this demographic shift should also slow the drain on government coffers by keeping down the dependency ratio: the proportion of people too young or old to work relative to the working-age population.
Perhaps the most illustrative example of this demographic dividend is Nigeria. Its population is predicted by the United Nations to rise from its present 175 million to 440 million by 2050, putting the country on pace to overtake the U.S. as the world’s third most populous country. In addition, the dependency ratio is expected to drop over the same period, from 0.9 to 0.7. Sub-Saharan Africa as a whole stands to gain from its rapidly growing population, which is helping fuel rapid increases in GDP. Sub-Saharan African output will grow by 6 percent in 2014, according to the International Monetary Fund. We can expect large increases in sovereign bond issuance, such as the upcoming one in Kenya, to fund the infrastructure necessary for this economic boom.
The economics and demographics of many emerging markets look good from our perspective, but what about the politics? The recent dispute between Ukraine and Russia has hit both Ukrainian and Russian bonds, and turmoil in Egypt in recent months has generated volatility in its sovereign yields.
True, political unrest can be bad for emerging-markets bond investors. Many emerging markets are seeing progress toward greater political stability, however, a development little noticed by the media, which for understandable reasons concentrate on the more sensational bad-news stories of instability.
In Africa, for example, various incarnations of democracy — albeit sometimes rather delicate incarnations — are spreading gradually through the continent, with recent progress in Angola, for example. In general, democratic systems tend to make economies more efficient — and better able to support government debt — by reducing the power of crony capitalism, in which an inefficient and uncompetitive economy is based primarily around powerful magnates’ personal connections with the ruling dictator and his family. Democracies are also more likely to honor debts than are dictatorships, in which payment or nonpayment is left to the whim of an individual.
In fact, the prospect that tapering will hit capital flows to emerging markets remains a bigger worry for many investors than are concerns about politics. We need to keep this in perspective, though. For many developed-markets bonds, as central banks raise interest rates, there is only one direction for prices: down. Many emerging markets, by contrast, could see both upward and downward volatility in bond prices in response to continued tapering — as some investors return money to their home markets and others jump in to take advantage of opportunities for finding value.
It is, for sure, never a good idea to choose an investment primarily because the alternatives are unappetizing. But the unattractive pricing and fundamentals of many developed-markets bonds should at least be considered when pondering the virtues of emerging-markets debt. Yields in developed markets are generally low, particularly for sovereign bonds, even though debt-to-GDP ratios are much higher than for many emerging markets. For a given level of risk, many developed-market bonds, both sovereign and corporate, look expensive relative to emerging debt.
Emerging-markets yields can, by contrast, be very high — even for the less volatile economies. For example, Nigerian naira-denominated, local government short-term bonds can offer yields of 12 or 13 percent, which, in some cases, are notably more attractive than yields on developed-markets bonds with comparable risk levels.
Local-currency investments are, of course, inherently risky — but we believe they should still form a part of international investors’ portfolios, depending on one’s investment profile and risk tolerance. The yields are often higher than for bonds denominated in a hard currency and are likely to be supported in future by the growth of local institutional investors and of a middle class prepared to buy bonds issued by nationally known and trusted banks and high-profile companies. Many utilities, for example, may have the scale and strong income stream necessary to issue creditworthy and attractive bonds.
For all the reasons cited, investors in general have decided to stay in emerging-markets bonds. Both Mexico and Turkey have issued significant amounts of dollar-denominated bonds so far this year, in sales that were largely oversubscribed. The thriving market in bonds from Turkey, a country at the center of the present emerging-markets financial and political turmoil, confirms the existence of a reliable investor base, even for riskier countries with high current-account deficits, if the price is good enough. Buyers were attracted by the Turkish central bank’s sharp hike in interest rates, which has brought the yield on ten-year bonds up to 10.4 percent. This will calm investors by reducing the current-account deficit, as well as offering an attractive rate of return. We believe it is, in short, not time to jump ship from emerging-markets debt. On the contrary, we believe it is time to start looking at buying whenever the ship dips. From our perspective, unjustified market nervousness is always the friend of the long-term investor.
Brett Diment is head of emerging-markets and sovereign debt at Aberdeen Asset Management in London.
