I’ll admit it; I am a sucker for “too soon” jokes. Perhaps they are a welcomed over correction to spending most of the time complying with social constraints. Perhaps it’s just a character weakness. Either way, I like a comedian that will push the boundaries. Finance has it’s “too soon” moments as well albeit of a slightly different flavor. You still might squirm in your chair a bit, but instead getting a good laugh, being too soon in finance forces a decision on whether it truly is too soon or just wrong. Feel free to click here to read a March post I put up about emerging market bonds – a recommendation that was indeed a bit too soon.
Bond Process: Intermediate in nature
My general investment thought process and outlook doesn’t produce a ton of adjustments in fixed income. Rather than trying to navigate each smaller twist and turn, my process tends to identify those times when it’s time to take total conviction in a particular direction. Because these times are few and far between, it’s important to get the calls right. More importantly, it is necessary to be able to admit and throw in the towel quickly when those calls are wrong. Three recent examples of such tilts have been heavily detailed here on this blog (congrats to the two of you who scrolled through the end). In August of 2016, the “tilt conviction” was to take a cautious stance on interest rate risk and last summer it was to begin piling into TIPS. Both of those were very helpful in setting up the portfolio better than its passive investing alternative (the Barclays Aggregate Bond Index)
EM Debt: Wrong thus far
This last one from earlier this year in March, to include healthy doses of external (or dollar denominated) emerging market debt has certainly been wrong thus far. You can see in the chart below that external emerging market debt (blue line below) has a total return of –2.8%, vs a slight gain for the aggregate bond index and healthy gains for high yield debt. Central to this under performance of emerging market debt has been a couple of variables that I won’t dive in too deeply here. But, a) the current trade wars are a major threat to emerging market economies (in addition to ours) and b) the dollar has been extremely strong – which is also a headwind for the asset class. This has been a double whammy:
At this juncture, you certainly have to respect the fact that the outcome of our trade wars are uncertain – and really bad outcomes certainly have a probability greater than 0. But, so do outcomes where the headlines were worse than reality and we are able to avoid the worst. What this means to me is that it is important to have some limits to how much exposure one has to the volatile group, but the case laid out in March remains intact. As such, I shall leave this call as too soon and stay the course with emerging market debt in the portfolios.
Summary of the case
A brief summary of the emerging market case is as follows: Many emerging economies have stronger growth outlooks than the developed world and are still in the midst of an upgrade cycle. So over time – we should continue to see the extra yield that emerging bonds carry will continue to compress towards developed world yields. The improvements won’t happen in a straight line, but over time I still suspect there to be a long term convergence.
Also, these emerging market sovereign bonds have ratings that are superior to US junk bonds. But the extra yield an investor gets for stepping into junk is razor thin, leaving it less than appetizing to assume such risk. Since this March post, these yield differentials have moved back near 2016 levels – an area that was fantastic for entering emerging market bonds.
Key to this recommendation in its full was that the call for emerging market debt itself was independent of the duration/credit choices in portfolio. It was simply that a portion of those risk allocations – whatever that may be for you – should be coming from emerging market bonds. Again, it should be limited it because the trade risks are real, but should still be “overweight”. In FEG’s case, our overall duration for fixed income in our balanced model is 4.9. But, Emerging markets make up about 15% of that duration.
Perhaps soon upping the ante:
One caveat I wish to submit now vs. the March review is the focus on dollar denominated / external debt. Back in March – it was made clear that the argument was being applied only to US dollar denominated debt so as to be more insulated from currency risk. Local currency debt is in the chart above as orange – shows the pretty steep losses in these bonds as they have been punished. But, the US dollar has been on a very strong multi-month expansion. Sentiment on the dollar has turned very, very bullish – and that can often be time to begin moving more towards a contrarian stance. A softer dollar would take some pressure off many emerging economies in general, but it would have a much stronger impact on local currency debt. We aren’t quite yet to the point of fully make that adjustment from external debt to local currency – but are getting close. If it can turn the corner in the coming weeks, it could very well be worth the risk to move on out to this local currency denominated debt.
