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Emerging market investmentsCurrent developments and long-term prospects
Research Insights – November 2018
Key messages
� Investments in emerging markets have performed
disappointingly so far in 2018.
� The high external vulnerability of individual countries has
proved to be their downfall. Concerns about contagion
to other emerging economies have led to a broad sell-off
of emerging market assets. However, these concerns
are likely to be exaggerated, as most emerging markets
remain fundamentally sound.
� Once investor concerns are at ease and their focus
again shifts to fundamentals, emerging market assets
will recover.
� Therefore, investors should not lose sight of the fact that
the long-term structural and fundamental conditions for
investments in emerging markets remain largely positive,
despite the current disappointing market trend.
� Emerging markets are economically speaking
underrepresented in global market indices. Therefore, the
Princely Strategy’s regional allocation is based primarily
on the risk/return profile of investments, using various
macroeconomic scenarios rather than global benchmarks.
� Depending on the environment, the Princely Strategy›s
allocation to emerging markets within equities, bonds and
private markets may change over time. Irrespective of this,
emerging market investments form an important anchor
for the long-term asset allocation of the Princely Strategy.
� Given the wide variety of emerging markets and the
increased political and institutional risks, we believe that
active implementation in these asset classes is essential in
order to reduce the risk of loss and to benefit from local
specialist knowledge.
Cov
er: F
loat
ing
Mar
ket
Bang
kok
Tour
, Tha
iland
Contents
4 Introduction
6 Fundamental data indicate an overreaction
7 Long-term growth drivers remain intact
8 Political and structural challenges raise the level of uncertainty
10 Underrepresented in benchmark indices
11 Emerging market investments as part of the Princely Strategy
12 Focus on local currency bonds
14 Focus on hard currency bonds
16 Focus on emerging market equities
18 Summary
Introduction
The past few years have proved challenging for a wide
range of investment strategies, styles, classes and regions,
including emerging market investments. While they initially
recovered relatively quickly in the wake of the largest financial
crisis of the post-war period, they have since been exposed to
periodic headwinds.
However, it is precisely when an investment is trending
well below long-term expectations that negative reports,
commentaries and analyses tend to appear. In such situations,
it is often difficult to tune out the noise and take an objective
view instead.
This holds true not only for the tactical positioning, which is
the immediate attractiveness of the investments against the
backdrop of the cyclical economy and the political environment.
In addition, it is especially important in regards to long-term
asset allocation. The focus here is on the fundamental value
drivers of an investment and its characteristics in the context of
the overall portfolio.
Drivers of the disappointing performance in 2018
2018 has proved to be particularly challenging for investments
in emerging markets (EM), as investors have suffered significant
losses on their equity and bond investments.
� EM hard-currency bonds are predominantly denominated
in US dollars and have therefore suffered from the rising
US yield curve and an increase in the risk premiums of the
index heavyweights Argentina, Turkey and Venezuela, whose
credit spreads rose by more than ten percentage points in the
course of the year.
� EM local currency bonds were on average neutral in their
respective local currencies, thereby investors only suffered
losses on the currency side. Currencies depreciated against
the euro by around 4.5%. Since the greenback rose at
the same time, the loss from a US dollar perspective is
significantly higher.
� Equity investments in emerging markets suffered the most,
due to lower earnings expectations, a correction in valuations
and currency losses.
1 Period considered: December 31, 2017 to October 31, 2018. Indices: JPM EMBI Global (hedged), JPM GBI-EM Global Diversified, MSCI Emerging Markets (NR). The index for hard currency bonds is hedged against the US dollar and euro. The return in euros, which was around two percentage points lower, stems from the costs of currency hedging from the US dollar to the euro.
Performance of emerging market investments
(January to October 2018)1
Source: LGT Capital Partners, Thomson Reuters
-5.6%
-9.9%
-15.7%
-7.9%
-4.6%
-10.7%
-20%
-15%
-10%
-5%
0%
EM hardcurrency bonds
EM localcurrency bonds EM equities
in USD in EUR
4
The main causes for the negative performance of the
investments are not only to be found in the emerging
markets, however also in the US. Firstly, the trade conflict
between the US and China intensified over the course of the
year. Thus, there was an increase in investor uncertainty about
US trade policy and the geopolitical situation, which led to a
rise in risk premiums and a correction in the valuations of EM
investments. Chinese companies related to the US economy
and the technology sector, which are directly affected by
President Trump’s measures, were hit particularly hard.
Secondly, the stronger than originally anticipated US economy
has caused the Fed to steadily tighten monetary policy, leading
to rising interest rates and a strong US dollar. Both of these
factors make it difficult to service USD-denominated debt, which
is why countries, such as Argentina, Turkey and South Africa,
with high external financing needs, came under pressure. Lastly,
the price of oil has risen by over 30% since mid-2017, which
has additionally burdened the current account balances of net
oil importers, such as India and Turkey.
The implications of US monetary policy for the development
of emerging markets is currently the subject of controversial
debate among analysts. Although it is undisputed that the
global tightening of monetary policy, which is driven by
interest rate hikes by the US Federal Reserve, makes refinancing
conditions in emerging markets more difficult, opinions differ
as to whether this will inevitably lead to crisis-like developments
in the emerging markets with the weakest fundamentals in a
domino movement, or whether the crisis-like developments of
recent months in Argentina and Turkey can be traced back to
country-specific undesirable developments.
We believe that Argentina’s balance of payments crisis
and Turkey’s sharp currency devaluation are not due to
US monetary and trade policy, but rather to negative local
developments. Turkish President Recep Erdogan, for instance,
is reacting in an increasingly authoritarian manner and exerting
greater pressure on local institutions such as the central bank,
whose independence is in question. In addition, the political
conflict with the US government, which resulted in sanctions
against Turkey, had a negative impact. In Argentina, the
central bank’s decision towards the end of 2017 to tolerate a
higher inflation rate in the future undermined the still fragile
confidence of the local population and investors, which lead
to a flight from the peso.
Worried that these local problems could also cause issues for
other emerging markets and ultimately lead to a similar kind
of repetition to the Asian crisis of the late 1990s, international
investors have taken the precautionary approach of reducing
positions, and thus are putting pressure on other currencies
in the process. Falling currencies and rising energy prices have
increased inflationary pressure in many emerging markets,
prompting central banks to make precautionary interest rate
moves, as seen in India, Indonesia, Russia and Mexico. However,
this response from the central banks, exemplary as it might
seem, has created additional uncertainty in some places, since
some market participants viewed this as confirmation of their
fears of a spreading currency crisis. Furthermore, in Asia, there
were rising concerns over second-round effects from the
US-Chinese trade conflict, which could also impact smaller
countries that are highly dependent on China due to the export
channel and the cross-border value chains. As a result, emerging
market investments, from equities to credit and bonds,
corrected sharply in the third quarter of the year.
5
Fundamental data indicate an overreaction
The fact that the correction was so sharp is among others
due to the investor structure, which has changed significantly
over the past decade. The zero interest rate and QE policies
seen around the globe have pushed investors into riskier
markets where they have limited experience, such as into
emerging market investments. As the negative news from
emerging markets has accumulated over the year, many of
these rather tactically oriented investors fled back to their
known markets. Since these investors mainly use passive
instruments such as ETFs, they were relatively indiscriminate in
their selling, thereby punishing not only the weaker countries,
but the entire region. Thus, individual fundamental issues that
were unique to one country ultimately resulted in a systematic
punishment of emerging market investments in general. This
is also consistent with the current extremely negative investor
sentiment, which we recently experienced ourselves at the
IMF’s autumn meeting and which has been confirmed in a
wide range of surveys among investors and asset managers.
As long-term investor, we must distinguish between a contagion
of prices and a contagion of underlying fundamentals. However,
we believe that the latter is not the case. On the contrary, the
emerging markets are performing better today than they were
during past crises, such as during the Tequila crisis or the Asian
crisis. Furthermore, they have continued to improve over the last
few years. In addition, external conditions as a whole remain
positive for emerging markets. Global expansion is continuing
despite a modest slowdown, and commodity prices have
stabilized again following the major correction in 2014/2015.
Not a typical emerging market crisis
Historically, most emerging market crises (Latin American crisis
1982, Tequila crisis 1994, Asian crisis 1997/1998) have been
triggered by imbalances in the balance of payments. Such crises
typically emerged due to the currencies’ peg to the US dollar,
governments and private individuals being able to borrow
excessively in cheap short-term foreign currency loans, consume
beyond their means and thus drive the domestic economic
boom. Loans and debt service were denominated in US dollars,
however investments and income were denominated in local
currency. External debt and exchange rate risks increased,
while trade balances lagged. In certain instances, –such as
when triggered by an economic slowdown, political crises
or rising US interest rates, the sustainability of the currency
peg was questioned, and the pressure on the balance of
payments increased. Foreign exchange reserves revealed to be
disproportionately small and unable to support the currency over
the long run, and central banks were forced to sharply devalue
their currencies. Hidden exchange rate risks now materialized,
which makes it impossible to service foreign debt, and often
leads to a combined currency, bank and sovereign debt crisis.
These crises cannot be compared with the current situation in
the emerging markets. As firstly, the vast majority of emerging
markets today have flexible exchange rates, which means that
it is not possible to accumulate foreign exchange risk to the
same extent. The currencies assume the function of a buffer,
thereby excessive pressure does not accumulate in the balance
of payments, however can escape via a currency devaluation.
The associated currency losses are hard to digest for investors,
however in return the risk of payment defaults or local financial
crises is ultimately reduced. Secondly, emerging markets are
currently also borrowing abroad. However, mainly in their
domestic currency rather than in hard currencies, such as
the US dollar or the euro, which reduces exchange rate risks
on borrowers’ balance sheets. Third, a large part of foreign
currency debt today is held by commodity companies, which
also generate their revenue in US dollars. In addition, emerging
markets currently have significantly higher and adequate foreign
exchange reserves. Lastly, trade balances are more stable.
2 Emerging markets excluding China, weighted according to GDP adjusted for purchasing power.
10%
20%
30%
40%
50%
0%
5%
10%
15%
20%
25%
1980 1985 1990 1995 2000 2005 2010 2015 2020
FX reserves (% of GDP)
External debt (% of GDP) – rhs
Source: LGT Capital Partners AG, Oxford Economics
Foreign currency reserves and foreign debt2
6
Furthermore, long-term growth forecasts anticipate higher
growth in the emerging markets in the coming years, as their
structural growth drivers remain intact. Emerging economies are
benefiting from the “demographic dividend.” Positive overall
population growth and a supportive age structure will allow the
working age population to continue to grow strongly over the
coming decades, while in the industrialized countries this figure
has been declining since 2015.
In addition, emerging economies have a higher rate of
productivity growth. Specifically, not only is the number of
workers increasing, however also their output. They benefit,
for instance, from rising levels of education, the implementation
of economic reforms, the expansion of infrastructure and
increasing urbanization. This is because the population
concentration associated with urbanization results increased
efficiency and economies of scale, such as in infrastructure and
logistics. However, the greatest productivity increases are based
on technological progress. In the past, this was mainly through
the adaptation of technologies from industrialized countries.
Today, it is also through their own research and development
in high-tech areas, such as robotics, biotechnology or artificial
intelligence. With the rising prosperity of the population, an
increase in the average propensity to consume can also be
observed, which is causing the consumer sector in particular to
grow disproportionately. In other words, emerging economies
will continue to create a large amount of value over the coming
decades. This will undoubtedly create various opportunities for
companies and investors.
Long-term growth drivers remain intact
Source: LGT Capital Partners, United Nations Population Division
3 Industrialized countries: More developed regions; emerging markets: Less developed regions, excluding least developed countries; working age: 15 to 69.
Source: LGT Capital Partners, United Nations Population Division
Working-age population (in millions)3
0
1 000
2 000
3 000
4 000
5 000
1980 1990 2000 2010 2020 2030 2040
Developed countries Emerging countries
Annual growth rate
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1980 1990 2000 2010 2020 2030 2040
Developed countries Emerging countries
Source: LGT Capital Partners, Oxford Economics
Productivity growth (per employee, annualized)
0%
2%
4%
6%
8%
10%
US
Gre
at B
rita
in
Ger
man
y
Fran
ce
Jap
an
Ital
y
Chi
na
Ind
ia
Ind
on
esia
Pola
nd
Sou
th K
ore
a
Russ
ia
Bra
zil
Sou
th A
fric
a
Mex
ico
2000 to 2018 2018 to 2030 (Estimate)
77
Political and structural challenges raise the level of uncertainty
Parallel to the excellent long-term growth prospects, emerging
markets may face numerous challenges over the next few years.
An instance of such is that in various places, necessary structural
reforms must be introduced or continued. Yet, many of these
reforms are unpleasant in the short to medium term for the
electorate, who could punish the ruling government in the next
elections, which particularly applies to Latin America. In Mexico,
the new left-wing government wishes to reverse the reforms
of recent years. In Argentina, President Mauricio Macri must
lead the country out of the balance of payments crisis through
unpleasant policies, while at the same time, securing the favor
of voters for the elections in 2019. Furthermore in Brazil, the
new government must illustrate that they can continue the
structural reforms that have begun and secure the stabilization
of public finances.
Moreover, the specter of populism is spreading not only to
mature democracies, such as the US or Europe, where control
mechanisms have been established to limit its dangers. Yet,
populism is also rampant in various politically less stable
emerging countries such as Brazil, Turkey, the Philippines
and South Africa. This is endangering not only liberal values,
however also the status and protection of international
investors. These political risks have been neglected in recent
years, due to the oversupply of liquidity to the global economy
and financial markets. In this respect, an increase in premiums
is certainly justified.
In China, the government is working on restructuring
the economy. The emphasis is on shifting the focus from
government investments to private consumption, while
simultaneously increasing financial stability, reducing harmful
emissions and modernizing domestic industry. However, as with
all structural reforms, the costs are immediate and it may take
several years for an impact to become apparent. China’s reforms
are undoubtedly positive in the long-term, however economic
growth will slow down during the reform and transformation
phase, which may have a negative impact on other emerging
economies in the medium term. In addition, it is rather
difficult to restructure the Chinese economy. However, we
assume that this will ultimately succeed, despite the chance
that some obstacles may be present. This assumption is due to
the fact that the Chinese government has the will, the means
and the experience to do so. Yet, an accident in the form of a
hard landing for the Chinese economy cannot be completely
ruled out.
In addition, the US-Chinese conflict will prevail. The dispute is
only superficially about tariffs, which are low and will remain
low in the event of a significant increase compared to China’s
economic strength and can be mitigated with appropriate
countermeasures. Moreover, both parties have no interest in
a dramatic escalation. Rather, the dispute must be seen in a
broader geostrategic context. The US, the de facto sole world
power since the collapse of the Soviet Union, will be challenged
8
over the coming years by emerging China both economically
and geopolitically, as well as, militarily. China’s leadership relies
on state capitalism and protects key industries by restricting
access to markets or imposing the transfer of know-how on
foreign firms. US President Donald Trump wants his trade tariffs
to force China to make concessions in industrial policy, thereby
demanding reciprocity and slowing China’s rise. In addition,
the US is increasingly demonstrating its military strength in the
South China Sea, where mutual provocations between the two
military forces regularly take place and thus increases the chance
for an accidental escalation. We expect the US-Chinese rivalry to
intensify over the coming years.
However, there are also challenges present in the industrialized
countries. Technological advances in the fields of automation,
robotics and artificial intelligence have the potential to
significantly increase productivity and growth in industrialized
countries over the next decade. For example, the new
technologies will allow a partial relocation of production steps
from locations with cheap labor, such as emerging economies
to industrialized countries. The consulting firm McKinsey, for
instance, estimates that the introduction and widespread use
of artificial intelligence in industrialized countries could make
a positive contribution to growth of around 1.5 percentage
points.4 This would partly undermine relative advantages of
emerging economies, such as cheap labor or higher structural
growth. In addition, protectionist US trade policy is one of the
factors that is promoting this technology-driven shift back to
industrialized countries.
In the medium term, global value chains could be somewhat
disrupted and become more strongly regionally oriented, which
in some places could also lead to less dependence on the US
or European economy. Another possible consequence could be
that today’s highly globalized world increasingly forms regional
geostrategic and trade blocs, such as around the US, Europe,
Russia and China. Signs of this movement have been observed
for some time, particularly in Asia. In Southeast Asia, for
instance, the ASEAN states and China created the world’s largest
free-trade zone around 10 years ago, with a population of over
1.9 billion. With its new Silk Road initiative (also known as “One
belt, one road”), China is building a gigantic intercontinental
trade and infrastructure network that extends by sea and land
from China via Central Asia and the Middle East to Europe. The
Chinese “belt” is to be understood as a two-pronged strategy.
It is considered to be a charm offensive on its southwestern
neighbors, however also as a means of further consolidating
economic and geopolitical influence on neighboring countries.
4 McKinsey Global Institute, September 2018, “Notes from the AI frontier: Modeling the impact of AI on the world economy”.
99
How should the weighting of emerging market assets in
strategic asset allocation be determined? Many investors
are surprisingly unfamiliar with questions regarding regional
allocation. Instead, their allocation is similar to that of widely
used benchmark indices, thereby delegating the decision to
these benchmarks. The logic behind this is that if you follow
these indices in your investments, it is similar to investing in
the overall market and therefore you can’t go “wrong.” This is
despite the fact that most investors are aware of the pitfalls of
these benchmarks.5
Emerging markets typically compose a small portion of
these benchmark indices. The reasons for this being the lower
proportion of companies that are listed on the stock exchange
and instead are held privately, or the exclusion criteria of index
providers with regard to market access and liquidity, or possible
capital controls. Their low weighting in global indices contrasts
sharply with the high economic and geopolitical weight of
emerging markets. Although emerging markets represent
around 85% of the global population and 40% of global
value added, they account for only around 5% to 10% of the
weighting in global equity and bond indices. In other words,
emerging markets are significantly underrepresented in global
market indices.
For investors the focus is not on today’s economic strength,
however on how it will develop going forward. Over the next
decade, more than half of global growth will be generated in
the emerging markets with various forecasts even stating that
it could be up to two-thirds. Yet, investing based on global
indices would mean an allocation of only about 10% of capital
to this region and as a result only marginal benefits from this
substantial contribution to growth.
However, emerging markets are also gaining in importance
beyond GDP statistics, as they are playing an increasingly
important geopolitical role. In 2005, the G7 summit was
expanded to include the most important emerging countries
and was replaced in 2008 by the G20, half of which are
emerging countries. China tops the list, as it grows more
confident in its foreign policy. Over the next two decades,
China will increasingly challenge the position of the US, as the
undisputed global superpower.
Index providers decide on the inclusion or reclassification of
markets in regular reviews. The share of emerging markets in
the global indices will therefore continue to grow due to the
increasing openness of their capital markets, better access for
international investors and greater liquidity of investments. In
particular, China and India will have a greater weighting in the
global indices. However, these adjustments are mainly based
on technical aspects and from an economic point of view, are
perceived only after a long delay. According to the MSCI, South
Korea is still considered an emerging country, even though it has
a higher per capita income than countries such as, Spain or Italy
(on a PPP-adjusted basis).
Therefore, similar to the Princely Family, other long-term
investors should not base their asset allocation primarily on
global benchmark indices, rather they should base them on
an assessment of the risk-return profile of asset classes in the
context of their own risk profile.
5 On the equity side, for example, companies are weighted on the basis of their market capitalization, with an overvalued company receiving a comparatively higher weighting and companies or regions with cheaper valuations receiving a lower allocation, despite the associated better long-term return prospects. On the bond side, the greater the debt, the greater the weighting and capital an issuer receives. Indices, therefore, tend to “reward” a higher price or loss risk with a greater allocation. From an investor point of view, such strategies are not worthwhile.
Underrepresented in benchmark indices
Importance of emerging markets based on population, value
creation and benchmarks
Source: LGT Capital Partners, UNO, Oxford Economics, MSCI AC World, JPM GBI Global, JPM
GBI-EM Global
5% 11%40%
66%86% 95%
0%
20%
40%
60%
80%
100%
Governmentbonds
Equities 2018 Growthshare until 2030
2018 Growthshare until
2030
Global capitalmarkets
Global economicactivity
(GDP in USD)
Global population
Emerging and developing economies Advanced economies
10
Since their inception some 20 years ago, investments in
emerging markets have been an integral part of the strategic
asset allocation of the Princely Strategy. In the global bond
segment, a substantial portion is invested in hard and local
currency bonds from emerging markets. Both offer attractive
interest rates that substantially offset the inherent risk of loss in
the long-term. As for equities, emerging markets are weighted
significantly higher than in typical global equity indices, in line
with their economic importance. In addition to investments
in public markets, the Princely Strategy is also increasingly
investing in emerging markets in the private markets area. The
weighting of the emerging markets in the individual areas is not
determined by benchmark weighting or market capitalization,
however by their long-term risk-return outlook and taking into
account various macroeconomic scenarios.
Yet, this does not mean that the Princely Strategy always keeps
its allocation to emerging market investments at the same level.
Since the returns on emerging market investments fluctuate
much more than the returns on global equities or government
bonds, they can also suffer longer periods of drought, despite
their attractive long-term return prospects. Conversely, emerging
market investments can also outperform their long-term
expectations if there is a corresponding tailwind from the cyclical
side and external factors. These phases can last a few months,
as well as, several quarters. Therefore, the Princely Strategy
makes adjustments on occasion to its tactical positioning and
to its strategic allocation to emerging market investments in
line with the short- to mid-term assessment of the political and
economic outlook and the market situation.
Active implementation particularly important
for emerging market investments
In our view, active implementation is indispensable when
investing in emerging markets. Firstly, the label “emerging
economies” refers to a diverse group of countries that differ
far more from each other than industrialized countries, in
terms of the form of government, economic structure, trading
partners, governance, legal system and level of prosperity.
Therefore, global cyclical factors, such as interest rates or
economic momentum, affect the individual emerging markets
and their companies extremely different in some cases. However
geopolitical developments, such as the US-Chinese trade
dispute or structural trends, also showcases clear winners and
losers at the country, sector and company level. In addition,
the capital markets in emerging countries are widely regarded
as less efficient than in industrialized countries, partly due to
the much lower coverage by analysts. This results in attractive
opportunities for active investors.
In addition, an active investment approach can help to reduce
the greater risks of emerging market investments. This applies,
however, much less to price volatility, as it does to the risk of
permanent losses on individual investments that can occur, such
as through inadequate corporate governance, capital controls,
state influence or expropriation of investors and nationalization
of strategically important companies. Such considerations are
alien to many investors in industrialized countries, however
in the case of emerging markets, they can make a significant
contribution to the success or failure of investments.
As emerging markets have various political, legal and economic
unknowns, it is all the more vital that investment decisions are
not made in relation to the past, as is the case with passive,
index-replicating investments, however actively with an outlook
towards the future and risks of the individual investments.
Therefore, the Princely Strategy makes all its investments
in emerging markets, both in bonds and equities, through
specialized internal or external managers, who often have a
local presence in the respective markets and thus have vital local
expertise and extensive networks in the region in relation to the
politics and the economy.
Emerging market investments as part of the Princely Strategy
1111
Focus on local currency bonds
Local currency bonds are attractive as long-term investments,
mainly due to their carry. The performance of this asset class
is determined by three components: (1) interest rates, (2)
price change of the bonds in local currency and (3) currency
developments. The short-term performance or fluctuation is
mainly determined by the currency development, which still
holds true in 2018. However, as the following graph shows, the
interest contribution clearly dominates over the long-term. In
contrast, the contribution from the price performance of local
bonds has only been slightly positive, while the contribution
from currencies has been negative.
However, investors who wish to benefit from these attractive
interest rates must also take into account the exchange rate
risk. Therefore, the higher interest rates can also be regarded as
a premium for having to endure these currency fluctuations.7
The attractiveness of this premium for international investors
is determined by two following components: the level of the
premium and the currency risk it entails.
6 JPM GBI-EM Global Diversified (in USD). Period considered: October 31, 2003 to October 13, 2018 (15 years).7 The costs of hedging the individual currency risks corresponds approximately to the difference between the money market rate of the base currency and the money market rate of the respective currency. In order to hedge the currency risk, the interest rate advantage must therefore be waived.
Long-term return drivers6
Source: LGT Capital Partners, JP Morgan
50
100
150
200
250
300
350
2003 2006 2009 2012 2015 2018
Total return in USD Interest
Bond prices Currencies
Return contributions (in USD, annualized)6
Source: LGT Capital Partners, JP Morgan
6.6%
1.5%
-2.1%
5.9%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
9.0%
8.0%
Interest Bond prices Currencies Total return
12
1) The amount of the premium that an investor receives when
investing in emerging market local currency bonds instead of
domestic government bonds is reflected in the interest rate
difference between the two investments. Typically, not nominal,
however real returns are compared.8 This difference in real
interest rates is currently regarded as very attractive. Compared
to real interest rates in industrialized countries, which remain at
around 0%, real interest rates in emerging markets are around
3.5%. Thus, the premium on local currency bonds is at its
highest level since the financial crisis.
2) Assessing the currency risk is more challenging. The focus
is on vulnerability and valuation. As described above, most
emerging markets today are generally less vulnerable than in
1996 or 2007, with the exception of Argentina, Venezuela,
Turkey and South Africa, due to adequate currency reserves
and healthy basic balances. As a result, the probability of a
broad balance of payments crisis in the emerging markets can
be classified as low. In addition, emerging market currencies
are very favorably valued following the sharp correction in the
second half of 2018. This means that the potential for further
devaluations is rather low. In fact, investors should be able to
benefit from the currencies approaching their fair value again in
the upcoming years.
In short, local currency bonds offer an attractive source of
return, due to their high interest rates. However, these bonds
are at times associated with strong currency fluctuations. The
short-term total return of the asset class is, therefore, mainly
driven by currency trends. However, the longer the investment
horizon, the more dominant the influence of the interest
component, the carry. In addition, the asset class is currently
attractively valued, both in terms of the interest rate advantage
and the currency valuation.
8 The principle of purchasing power parity states that currency parities change according to differences in inflation. A higher rate of inflation in one currency i against another currency j is offset by a corresponding devaluation of currency i against j. Consequently, investors with base currency j cannot benefit from higher nominal interest rates in currency i insofar, as these are attributable to different inflation rates. Either the currency i depreciates, or its valuation increases and so does the risk.9 Industrialized countries: JPM GBI 7-10Y less inflation, GDP-weighted average from US, UK, Japan and EMU; emerging markets: JPM GBI-EM Gl. Div. less inflation, index-weighted average from Brazil, Indonesia, Colombia, Malaysia, Mexico, Peru, Poland, Romania, Russia, South Africa, Thailand, Czech Republic, Turkey and Hungary.
Source: LGT Capital Partners, JP Morgan, Thomson Reuters
Real interest rates on government bonds9
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
2008 2010 2012 2014 2016 2018
Real interest rate differential
Developed countries Emerging countries
Valuation of emerging market currencies against the USD
Source: LGT Capital Partners, Goldman Sachs, JP Morgan
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
2000 2003 2006 2009 2012 2015 2018
Overvalued
Undervalued
1313
Focus on hard currency bonds
In contrast to local currency bonds, hard currency bonds are
typically issued in US dollars, however increasingly also in euros.
These investments do not involve any direct currency risk for
investors. In return, investors bear an increased risk of default.10
A premium is paid to compensate investors for bearing the risk
that there will be more defaults than expected and for other
risks, such as potential illiquidity in times of stress or increased
volatility.11 Since the premiums on hard currency bonds are
usually significantly higher than the actual future defaults,
investors who invest in EM hard currency bonds instead of safe
government bonds can achieve an additional return over the
long run.
Historically, default rates for emerging market governments
have averaged around 0.8% per year.12 With a recovery rate of
around 40%, this results in an expected annual default loss of
only around 0.5%, while premiums over the past 20 years have
averaged around 4.5%. In the long-term, investors will clearly
benefit from an allocation to hard currency bonds.
10 If a government issues bonds in its local currency (local currency bonds), it can repay them at any time by printing its own currency. Investors, therefore, bear the devaluation or currency risk. However, if a government issues bonds in hard currency, there is a risk that it will no longer be able to service these debts in the future, or only partially. Thus, investors bear the default risk. However, both risks are closely linked. If a currency depreciates sharply, servicing debts in hard currency becomes more difficult and the risk of default rises accordingly.11 The premium is usually set from the credit spreads. The credit spread is the difference between the yield of a bond and the yield of risk-free bonds of the same duration and base currency, such as US Treasuries or German Bunds.12 Moody’s (2016), “Sovereign Default and Recovery Rates, 1983-2015.”13 Period considered: October 31, 1998 to October 13, 2018 (20 years). Global government bonds: FTSE World Government Bond Index (hedged in USD); hard currency bonds: JPM EMBI Global (in USD).14 JPM EMBI Global (in USD). Period considered: October 31, 1998 to October 13, 2018 (20 years).
Performance of bond indices (in USD)13
Source: LGT Capital Partners, FTSE, JP Morgan, Thomson Reuters
+132%
+478%
0
100
200
300
400
500
600
700
10/1998 10/2003 10/2008 10/2013 10/2018
Global government bonds Hard currency bonds Source: LGT Capital Partners, JP Morgan, Thomson Reuters
Return contributions (in USD, annualized)14
2.7%
2.4%
4.1% 9.2%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
Cash Duration EM premium Total return
14
The premium on hard currency bonds has risen significantly
since the beginning of 2018, amounting to around 4% at the
end of October 2018. Not only is it higher than the average
for the past 15 years, it is also significantly higher than the
premium, for example, on US corporate bonds, with US
corporate leverage currently close to an all-time high. In our
view, this reflects a mispricing of hard currency bonds based on
excessive pessimism towards emerging markets. Some market
participants are unwilling to invest in the asset class, as they
fear short-term price losses, due to the heightened uncertainty.
However, long-term investors who are willing to bear such
short-term price risks can benefit from the attractive premiums
in this asset class.
The Princely Strategy benefits from the premiums on hard-
currency bonds not only through its strategic allocation to the
asset class, however also through countercyclical purchases in
the event of major upheavals, such as in February 2016.
15 JPM EMBI Global (stripped spread, in basis points), capped at 600 basis points.16 Hard-currency bonds: 50% JPM EMBI Global BBB Rated (stripped spread), 50% JPM EMBI Global BB Rated (stripped spread). US corporate bonds: 50% ICE BofA/ML BBB US Corporate Index (OAS), 50% ICE BofA/ML BB US Corporate Index (OAS). Capped at 600 basis points.
Credit premium on hard currency bonds15
100
200
300
400
500
600
10/2003 10/2006 10/2009 10/2012 10/2015 10/2018
Credit spread Median
Comparison of risk premiums of the same quality16
Source: LGT Capital Partners, JP Morgan, BofA/ML, Thomson Reuters
10/2004 04/2008 10/2011 04/2015 10/2018
EM hard currency bonds US corporate bonds
100
200
300
400
500
600
1515
Emerging market equities are particularly well-placed to benefit
directly from the strong economic growth of emerging markets.
Over the past 20 years, the MSCI Emerging Markets index has
outperformed by more than a factor of two its counterpart
from the industrialized countries, the MSCI World. The main
drivers of this performance were corporate earnings growth
and dividends, while the valuation (price/earnings ratio) and
currencies made a slightly negative contribution.17
However, higher long-term returns also go hand in hand with
greater risks. For instance, emerging market equities are typically
much more volatile than equities from the US or Japan. In
addition, investors who want to profit from the long-term excess
returns of the asset class must also reckon with longer dry spells.
Emerging market equities are often mistakenly considered to
be highly sensitive to commodity prices. From a fundamental
point of view, this was certainly partly justified in the past. The
share of commodity companies in the MSCI Emerging Markets
Index was around 30% between 2004 and 2011. However,
over the past few years, their share has been cut roughly in
half, while companies in the consumer and technology sectors
now account for over 40% of the total index. As a result,
emerging market returns are no longer driven by commodity
prices, however they are much more dependent on domestic
developments.
Focus on emerging market equities
17 As with local currency bonds, equity investments in emerging markets are typically not hedged against currency risk. In some currencies there are no suitable instruments for currency hedging, while in some currencies the costs are excessively high. 18 MSCI World (TR in USD) and MSCI Emerging Markets (TR in USD). Period considered: October 31, 1998 to October 13, 2018 (20 years).19 MSCI Emerging Markets (TR, in USD, annualized). Period considered: October 31, 1998 to October 13, 2018 (20 years).
Performance of equity markets (in USD, total return)18
Source: LGT Capital Partners, MSCI
+210%
+474%
0
100
200
300
400
500
600
700
800
10/1998 10/2002 10/2006 10/2010 10/2014 10/2018
MSCI World MSCI Emerging Markets
Return contributions (in USD, annualized)19
Source: LGT Capital Partners, MSCI
0%
5%
10%
15%
20%
25%
30%
DividendsEarnings growth
ValuationCurrencies
Total return
6%
21%
-4%
-3%
19%
16
As can be seen above, the performance of equity investments
is mainly based on earnings growth and dividends, and only to
a small extent on valuation. On the other hand, for a somewhat
shorter period of about five years, the valuation of stock
markets can be a major driver of returns, especially if it is very
expensive or very cheap.
Emerging market equities have undergone a significant
valuation adjustment since 2011. Measured by common
multiples, they are currently trading at a discount of around
30% to their industrialized counterparts. This is despite the fact
that the return on equity has been on an upward trend for two
years and is at the same level as that found in the industrialized
countries. We expect this valuation discount to normalize
at least in part over the coming years and emerging market
equities to outperform the global equity index.
Valuation of MSCI EM relative to MSCI World
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
10/2003 10/2006 10/2009 10/2012 10/2015 10/2018
Price/earningsPrice/fwd EPSPrice/book
Source: LGT Capital Partners, MSCI
Composition of the MSCI EM: Commodity companies and
technology/consumer
0%
10%
20%
30%
40%
50%
1998 2002 2006 2010 2014 2018
Commodity sectors (energy and materials)
IT and consumer
1717
Summary
In some countries, there were undoubtedly some justified,
specific reasons for the negative performance. However, we
consider the fundamentals of most emerging markets to be
robust. Therefore, we hold the view that the majority of the
negative development is attributable to a change in sentiment
among international investors. The main reasons for this are
likely to be the harsh US trade policy, a rise in geopolitical
uncertainty and concerns about an excessive tightening of US
monetary policy. As investor concerns ease and the focus once
again shifts to fundamentals, emerging market assets are likely
to recover. This is because the structural growth drivers and the
drivers of long-term investment returns for stocks and bonds
in emerging countries remain intact, while developed countries
offer only subdued growth and low yield prospects.
Emerging economies will continue to be the main contributor of
global growth over the coming years, resulting in a wide range
of attractive long-term investment opportunities. Therefore,
emerging market investments are a vital anchor for the strategic
asset allocation of the Princely Strategy. The weighting of these
investments is not based on prevalent benchmarks, but on the
long-term risk-return outlook for the investments and their
properties within the context of the portfolio. In view of the
political and structural challenges, however, the importance
of active investment decisions and active management of
investment risks in emerging markets has also increased. In
order to benefit from local specialist knowledge and to reduce
the risk of permanent losses, the Princely Strategy actively
implements all emerging market investments.
18
Important informationThis marketing material was issued by LGT Capital Part-ners Ltd., Schützenstrasse 6, CH-8808 Pfäffikon, Swit-zerland and/or its affiliates (hereafter “LGT CP”) with the greatest of care and to the best of its knowledge and belief. LGT CP provides no guarantee with regard to its content and completeness and does not accept any liability for losses which might arise from making use of this information. The opinions expressed in this marke-ting material are those of LGT CP at the time of writing and are subject to change at any time without notice. If nothing is indicated to the contrary, all figures are unau-dited. This marketing material is provided for informati-
on purposes only and is for the exclusive use of the reci-pient. It does not constitute an offer or a recommendation to buy or sell financial instruments or services and does not release the recipient from exercis-ing his/her own judgment. The recipient is in particular recommended to check that the information provided is in line with his/her own circumstances with regard to any legal, regulatory, tax or other consequences, if ne-cessary with the help of a professional advisor. This mar-keting material may not be reproduced either in part or in full without the written permission of LGT CP. It is not intended for persons who, due to their nationality, place of residence, or any other reason are not permitted ac-
cess to such information under local law. Neither this marketing material nor any copy thereof may be sent, taken into or distributed in the United States or to U. S. persons. Every investment involves risk, especially with regard to fluctuations in value and return. Investments in foreign currencies involve the additional risk that the foreign currency might lose value against the investor’s reference currency. It should be noted that historical re-turns and financial market scenarios are no guarantee of future performance.
© LGT Capital Partners 2018. All rights reserved.
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LGT Capital Partners Ltd.Schuetzenstrasse 6, CH-8808 PfaeffikonPhone +41 55 415 96 00, [email protected]
www.lgtcp.com