Threadneedle: Can EM debt trade more tightly than the US?

Investors were too wrapped up in geopolitical risk in the first quarter and have lost sight of the impact of the 2008 credit crisis on the direction of financial markets, says UK asset manager Threadneedle.

The firm’s vice-chairwoman and former global CIO Sarah Arkle paid a flying visit to Hong Kong yesterday and stressed that a hunt for long-term value must start with an appreciation of GDP growth trends.

The world has been turned on its head in terms of national debt and deficits, she notes, with emerging markets far better placed than developed nations in terms of fiscal balances and government debt as a percentage of GDP (click chart, left).

“One needs to think where the risk is,” she tells AsianInvestor. “The credit crisis did not affect a number of emerging market banks, and yet emerging markets fell more than developed markets [post 2008].

“When there is a risk-off trade, a lot of emerging markets get unjustifiably punished. I would have to question some of the old relationships and perceptions that people have.

“A lot of [investing] in the first quarter was based around the impact of Japan [disaster] and geopolitical risk. But, to my mind, of far greater importance [to investing] is the credit crisis. This has a more lasting impact on what happens in markets and economies going forward.”

Threadneedle suspects the surge in US nominal GDP post Japan’s market peak in 1989 was driven not by any productivity miracle, but by leverage, with the US now unable to grow or inflate its way out of debt.

“I know people are concerned with geopolitical risk, but [fiscal debt] is arguably a bigger risk with a longer-term effect,” says Arkle.

As she points out, markets are either a buy on decline or a sell on rally. “I would certainly sell government bonds on rally now, and buy areas we like on decline, whether that’s equities, or Asia, or Hong Kong or China. The Japanese tsunami and earthquake was a buying opportunity.”

Threadneedle highlights a classic anomaly in global bond markets, for example, contrasting the picture for US and emerging market debt over the past 10 years.

Arkle notes that while the spread for dollar-denominated emerging market debt has come down, and arguably could drop further, the yield on local emerging market bonds remains high, and this at a time when a number of EM countries have seen their ratings upgraded.

“The fiscal deterioration is not priced in and arguably the fiscal improvement is not priced in. Such anomalies create opportunities,” she says. “I think you need to think the unthinkable. Could the debt of some of these emerging market countries trade more tightly than US debt?”

Further, Threadneedle finds equity dividend yields attractive relative to bonds, creating a ripe environment for stock-pickers. And Arkle believes geopolitical risks and other factors have largely been priced in to equity markets already.

She notes with regard to global prospective price-earnings (P/E) that markets are cheaper than in 2003 but not as low as 2009 (click chart, left). “If you look back, global P/Es are at the same level as they were in 1990. So where were interest rates in 1990? Relative to interest rates now, markets are cheap.”

Overall, Threadneedle is overweight Asia within global portfolios and within Asian portfolios favours Hong Kong (commercial property plays, not banks) and China, where it expects inflation to peak in the second half.

At an asset allocation level it favours equities, notably emerging markets where it has recently taken some profits, as well as emerging market and high-yield debt in countries including Brazil, Mexico and South Africa.

“What we are really trying to do is look at where there might be long-term value,” adds Arkle. “If there are worries over geopolitical concerns, that is where we would look to buy more.”