Facing the debt-ratings downgrade in the U.S. and the ongoing sovereign debt train wreck in western Europe, fixed income investors are taking a new look at government bonds from unexpected regions and accepting payment in unfamiliar currencies. Unlike previous booms in emerging market debt, which were driven principally by a search for yield, today's renewed interest reflects a changing and growth potential.
How ironic is it that the foreign reserve managers of several large emerging economies, Brazil, China and Turkey for example, are debating the conditions for making investments in bonds issued by the so-called developed countries' governments? At the same time this fall's almost daily heightening of global financial risk, while centered on the fiscal and debt problems of the developed world, struck hard at the market for emerging debt, especially at the increasing portion denominated in local emerging market currencies. In my opinion, this sell-off represents a knee-jerk, risk-off response and may create a valuable diversification opportunity for investors.
Those of us whose experience in financial markets can be measured in decades rather than months, painfully remember emerging market debt investors' recurrent cycles of enthusiasm and remorse. Bouts of fiscal and monetary crisis that shook Asia in the late 1990s and Latin America in the early 2000s appear, however, to have set many emerging economies on more sustainable policy paths. According the International Monetary Fund estimates shown in the top chart, several of the major emerging market governments have achieved public debt levels that are much better aligned with the size of their economies than comparable levels among developed market countries. Those of us in the U.S. might well note that our oft-maligned neighbor to the south has about half the gross government debt that we have.
Despite significant credit improvements, the combination of unfamiliarity, the history I mentioned above, and a pattern of tight monetary policy has given many emerging market bonds a yield advantage over U.S. treasury debt even accounting for local inflation. The bottom chart presents real ten-year yields for several developed and emerging issuers with the inflation- adjusted advantage clearly on the emerging markets' side. This advantage merits special consideration in the current, very low, expansionary-policy-driven environment for U.S. government debt.
A final consideration applies specifically to bonds that pay interest in local currencies. "What do I want with an income stream in Malaysian ringgit?" you might ask. The answer may lie on your clothing label. As countries' economies grow relative to the rest of the world, their currencies tend to appreciate relative to the currencies of more slowly growing economies. As an increasing portion of our manufactured goods come from emerging economies, receiving some of our investment income in the currencies of those more rapidly growing economies may help us preserve our purchasing power.
Recent market turmoil and investors' search for familiar and seemingly safe assets have helped U.S. government debt and the U.S. dollar to outperform the debt and currencies of many emerging markets. Some of that relative performance results from emotion dominating economics. For the prudent investor, that kind of market behavior is what creates potential opportunity.
Dr. Jerry Webman, Ph.D., CFA, serves as the Chief Economist
at OppenheimerFunds, Inc. in New York. He provides strategic
viewpoints on the overall financial and economic markets to
investment management and the financial advisor and investor
communities. He can be reached at this email address.
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