Emerging Market Bonds: Part 2
248% Profits on the Best Asset Class Of the Last 10 Years
An Investment U White Paper Report: Part 2 of a 3-Part Series
By the Investment U Research Team
Return to Part 1 of Emerging Market Bonds
Globalization Derailed What Happens When Government Crosses the Line
And it’s not just domestic companies that feel the pressure to perform. Governments and central banks must behave more like responsible players if they want to stay in the game. Otherwise, the full force and fury of foreign investors will descend upon the offending nation. The message will undoubtedly be: Get your act together or we’re heading home with our money!
In today’s environment, the primary obligation of government is to lay the necessary groundwork so that the private sector is ensured the optimal environment from which to meet globalization’s monumental challenges. This includes responsible tax-and-spend policies and a sound currency.
Doing so ensures that a country enjoys the bountiful growth opportunities that globalization offers. So governments can play by the rules and enjoy widespread support from foreign investors. Or they can act recklessly and become roadkill. It’s a simple choice really.
Argentina provides an unfortunate example. The Argentine politicians thought that the rules didn’t apply to them. They behaved irresponsibly, not heeding the global market’s warnings. Now they’re roadkill.
The resultant situation in Brazil also makes for a good case study. Brazilian investors became increasingly skittish in the runup to Brazil’s first- and second-round presidential elections that took place in October 2002. All the hubbub was over the fear that Luis Inácio Lula da Silva, a socialist-extremist candidate popularly known as “Lula,” would win the presidency, which he did in a second-round vote at the end of October.
Certainly all the populist, vote-garnering rhetoric spilling out of Lula’s mouth sounded scary to Brazilian investors. But the reality is that Lula’s administration is unable to adopt any radical anti-market measures that would risk the outlook of Brazil as a sound economy in which to invest period.
Any efforts to reverse Brazil’s integration into the global system, which is now well underway, will quickly plunge the country into a financial black hole.
Once a country has plugged into globalization, any efforts to unplug mean lights out. Such a reality has already revealed itself. As the elections neared and Brazilian markets tumbled, Lula increasingly veered to the right and began singing a more pragmatic, market-appeasing tune. Under pressure, a humbled Lula began telling foreign investors to ignore all the petty little populist comments he made earlier.
Globalization as Market Sheriff
So what exactly does all this mean? It means that the competition for capital under globalization, the freer movement of this capital, and the disciplinary force of the world’s capital markets has greatly restricted government maneuverability. In effect, globalization acts as a constant monitor – due diligence if you will – on financial performance worldwide, thus neutering governments of the ability to stray too far from prudent policies.
Political and economic policy choices – the right choices, that is – become quite narrow, restricting those in power to relatively tight parameters. Which is why voters are having a harder and harder time distinguishing between the economic platforms of opposing political parties. Reinvented socialists have stolen most of the capitalists’ economic policies – but with a so-called “compassionate” twist.
The reality: Globalization is an unstoppable process
Capitalism is the only model. Any attempts to steer the economic model back toward socialism would be suicide for a new government administration and the country it administers.
So investors should no longer discount the chance that any government, even in emerging markets, will suddenly change the rules and adopt wayward policies. Now that politicians in emerging nations understand this reality, emerging market sovereign bonds should be viewed as a more conservative investment and not a highly speculative one over the long haul.
Emerging market bond funds are government-guaranteedand governments, unlike corporations, rarely go bankrupt. Remember, the ability of new government administrations in emerging markets to suddenly abandon prudent policy has become remote. And just in case you’re still not convinced that emerging market bonds are attractive investments, there’s more where that came from.
4) Emerging Market Bonds: Accurately Assessing the Best Risk/Reward Ratios
Doom and gloom is still popular in today’s investment landscape. Equity investors in many markets continue to rush for the exits. Capital seeking a safe haven has piled relentlessly into the U.S. Treasury bond market, where yields hover near historic lows. Corporate bond investors have been hit by one large-scale bankruptcy shock after another. Emerging market investors have been frightened by recent traumas in Argentina and Brazil.
For investors, though, such uncertain times often present some of the best opportunities as confusion reigns and risk/reward ratios get thrown out of kilter. Yet the investment outlook is not entirely clear for most asset classes.
Perfectly credible cases can be made for stocks presently being undervalued or still overvalued. Likewise, the scenario of a sideways-moving stock market for several years is also entirely possible. (Current dividend yields are nothing to write home about either.)
In looking at other asset classes, the yield on U.S. Treasury bonds has become pitifully meager – reaching 40-year lows recently. The corporate bond category, both investment grade and junk, may have more skeletons left in the closet. Yet emerging market bonds remain the one asset class that seems to offer the best risk/reward ratio.
But First, Let’s Look at Stocks
It’s entirely possible that yesterday’s valuation methodologies have become outdated. If so, employing such irrelevant parameters warps the ability of many investors to assess true value. The claim that today’s high stock valuations and corporate/ consumer debt levels must revert back to lower historical norms is one example of an outdated yardstick.
Most historical benchmarks should have been dismantled at the same time the Berlin Wall suffered that fate. The Cold War was a bad apple; globalization is a sweet orange vastly different and incomparable economic environments.
A more credible argument would be that valuations should be higher now that the trend toward free markets is firmly entrenched throughout much of the world. Under such an environment, profit opportunities and improved standards of living can grow exponentially. Market risk thus becomes lower. Steadier income levels, solid productivity growth, and more sophisticated risk-assessment lending models would also allow for higher debt levels. And the list goes on.
On the other hand, the U.S. serves as the single most important growth engine for most of the world. So a U.S. that continues to be held back from a longer-than-expected recovery process could result in a period of secularly lower growth in many parts of the globe compared to the last two decades of the 20th century. The implications here would be flat equity markets in the medium term (at best) or more deterioration (at worst).
In turn, such a low-growth environment where the recent U.S. correction continues to grind the market could take more corporate victims down with it. And we may not have seen all the corporate accounting shenanigans flushed out yet. So corporate bonds may continue to reveal more nasty surprises.
In other words, where markets head from here is anyone’s guess. After all, we’re in a new globalized world. So the direction of stocks is a mystery and corporate bonds may still be a minefield. In the meantime, U.S. Treasury bonds now offer abysmally low yields.
So why not go for a high fixed yield with a relatively safe asset class? The attractive yields being offered on emerging market bonds more than compensate for the risk that the markets currently overestimate. Which is another way of saying that emerging market bond funds offer one of the best risk/reward ratios out there today.
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Cheer UpThe Global Economy Is Not Terminally Ill
As an aside, investors should be aware of the implications of open markets and freely flowing capital, not to mention more widespread information flows. In this environment, market corrections can be relentless and harsh, as the fat is mercilessly trimmed. The point is, don’t let recent market action harmfully darken your long-term outlook on the global economy.
Greater economic freedom under globalization allows for quicker recovery. And once the anticipation of economic recovery does fully emerge – and it eventually will – the typical reaction of investors is to increase risk appetite. Under such a scenario, emerging market bonds would be one of the first asset classes to benefit.
Even more compelling is that many of the emerging-market economies have since restructured and adopted more sound economic policies, as previously mentioned.
Most have had plenty of time to recover from their relatively distant financial crises that date back as early as the mid-1990s. In comparison, the U.S. is still undergoing the painful, yet necessary, therapy from the surgical removal of the bubble parts of its economy.
Other Market Traits Are At Work for Us, Too
And it never hurts to pay attention to what the large institutional investors (the “smart” money) are doing with their funds. Many have been looking to switch from equities to emerging market bonds as a suitable high-return substitute for their stock holdings.
And here’s another trait to pay attention to in consideration of emerging market bond funds. Americans now invest less outside the U.S. than they did 10 years ago. The emerging-market crises throughout the 1990s apparently scared them out. And it seems that they haven’t even bothered to reassess the foreign outlook for lucrative investment opportunities – you can be sure of their eventual detriment.
Getting a jump on the investment crowd before they realize the attractiveness of these bonds can be a lucrative strategy to us. 5) A Low Inflationary World: Good News for Bonds
The fifth critical point to be aware of is the lasting disinflationary, or outright deflationary, forces that are coming from all directions, which usually work to keep interest rates low – a definite plus for bonds (the value of bonds moves inversely to interest rates). And long-term bonds benefit in a low inflationary world; high inflation erodes the value of future fixed-income payments, rendering bonds with long maturities unattractive.
In such a new environment, the reaction by many investors in how they allocate their capital will be somewhat predictable. Emerging market bonds will likely become one of the primary beneficiaries given their attractive yields, especially once fears over Brazil and the global economy subside.
The following subsections go over the numerous reasons to expect a long-lasting, low-interest-rate and low-inflationary world.
- Graying Baby-Boomers. Aging demographic trends throughout the industrialized world provide a macro-force that will keep a lid on inflation for years to come. The populations of Japan, Europe and, to a lesser extent, the United States are living longer, hence more elderly consumers. Such a trend subdues demand and suggests higher savings rates ahead, thus minimizing upward pressure on prices.
- An Uptrend in Productivity. Once upon a time, one of the chief justifications for sky-high valuations among ever-bullish U.S. equity investors was the significantly higher level of productivity growth that companies were purportedly reaping from the unprecedented advances in technology. Now bearish commentators rant that the productivity improvement was merely a mirage. As usual, the truth lies somewhere in between.
We may, in fact, be experiencing a secular uptrend in corporate productivity growth. And it’s not just technology that is causing this uptrend. The competitive pressures applied by globalization certainly lend a helping hand. Indeed, higher productivity serves as a powerful anti-inflation force.
- Capitalism’s Noose Around Fiscal and Monetary Policy. The implications of globalization addressed above laid out another reason. The world’s capital markets keep governments and central banks in line. Prudent fiscal and monetary policies prevent reckless governments from wildly inflating away the value of their citizens’ money for political short-term needs. If they choose this route, then they’ll quickly become a cautionary tale.
- Cheap Labor. As pointed out earlier, free-market capitalism and the globalization consensus have survived the past decade’s faith tests. In fact, the rush remains to attract foreign investment and boost competitiveness. That’s why so many nations are still clamoring to join the World Trade Organization (WTO).
A vigorous globalized trading environment applies downward pressure on wage growth. Non-Western nations, such as highly populated China and India, offer an abundant resource that companies from more expensive nations wish to capitalize on, and that is cheap labor. As long as there is an abundant supply of cheap labor, downward pressure on wages throughout the world will remain.
- We’re All Competitors Now. The introduction of major low-wage exporting nations – China, with 1.5 billion people, being the most dominant one today – into the global trading network contributes mightily to disinflationary pressures in another way. In the giant market under globalization, we’re all competitors. It’s simple. The ability of low-wage China to produce goods cheaply and export them to the U.S. or any other nation lowers prices in the importing nation.
Deflationary pressures have gripped the goods-producing sector in Europe and the U.S. Today in America, overall inflation is running at just 1%, a 48-year low. In past economic cycles – including the current one, though to a lesser degree than before – the service sector has always been spared from deflationary forces. But the globalization of the service sector, spurred on by deregulation, cross-border mergers and acquisitions, and information technology, may not spare this sector for much longer.
Here’s an interesting bit of information: Did you know that the U.S. now imports more from China than from Japan? It’s no wonder that companies here complain of their lack of pricing power, which leads to another point. China is just getting started. India wants to become a competitor as well. As do others. How long do you think that today’s limited pricing power will last? And what are the implications for stock prices as profits continue to be squeezed in such a competitive environment? Going for yield ain’t looking too shabby now, huh?
- The Capacity Overhang. The bubble years also led to a buildup of too much production capacity, in an effort to meet outlandish growth forecasts. It will take a while before this excess capacity is absorbed into the market, which will dampen corporate investment for some time to come.
Under an environment of intense competition and excess capacity – combined with the ongoing deflating asset price bubble – the U.S. may grow below trend for a while longer until recovery is complete. Below-trend growth places downward pressure on inflation. Again, such a low-growth scenario does not bode too well for the stock market.
So where do investors – especially institutional investors who need to match their fixed liabilities – go to make any money, if not in the stock market? With so much uncertainty in the air, a good deal of investor funds have been parked into U.S. bonds with short maturities, which can be considered nothing more than cash.
But once nerves settle down, investors will be willing to take on additional risk. And without any fear of inflation and rising interest rates, high-yielding emerging market bonds will capture much investor interest.
Move on to Part 3 of our Emerging Market Bonds report.
Return to Part 1
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View the complete Emerging Market Bonds report as a .pdf file.
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