Emerging market debt sell-off signals a return of value

Boston  - In an October 5 blog post, we pointed out the "material risk" of a broad-based correction in emerging market (EM) debt. That broad-based correction is happening now.

The election of Donald Trump has raised the prospect of renewed inflation and faster growth in the U.S. Consequently, U.S. Treasury yields have increased meaningfully.

The chart below shows the drop in the three major EM sectors - sovereign, dollar-denominated debt; local currency debt; and corporate debt. The local currency index is off the most, down 8% since the beginning of the quarter. This is not surprising, given that EM currencies are liquid and highly volatile.

To put this in perspective, EM debt had rallied sharply all year. Through October 31, local currency debt total return was 16.1%; sovereign, dollar-denominated was 13.3%; and corporate was 11.1%. Clearly, it was a good run, in part because global investors were reaching for yield.

In times of market stress, we find it useful to revisit some of our basic investment principles, including:

• Short-term investing and speculation amount to a fool's game.
• Investment is about valuation - on an absolute basis and relative to other sectors.
• The key to investment success lies with strong fundamental analysis and risk management.

We are not in the business of making short-term investment calls. But we believe that there has been pockets of value in EM for investors willing to take a multi-year horizon. With this sell-off those pockets are growing. While rising rates in the U.S. can be a negative factor for EM debt, context is important.

If rate increases are a sign that Trump and the Republican Congress are succeeding with pro-growth policies in the U.S., that would be very positive for emerging market economies, and likely outweigh the impact of tighter monetary conditions. The stock market rally since the election appears to be at least an initial vote of confidence in the positive scenario.

Doing one's homework will be key. Investors will need to not only follow the new administration closely for clues about economic and foreign policy, but also sort through some hundred-odd EM economies. There will be winners and losers.

Bottom line:  For investors who are interested in EM debt, but are concerned that this year's rally got away from them, a window is now opening up. From a valuation perspective, EM debt looks much more interesting.