New York, March 5, 2013, Advisor Update®
Those of you familiar with our portfolio know that one of our favorite positions over the years has been emerging market debt. We have written extensively on the topic, and our outlook has been reflected by the exceptional risk-adjusted returns provided by EM bonds in recent years.
Our outlook on EM debt has been rooted in many factors, but most important is that in comparison with developed market countries, emerging markets offer better growth prospects, demographics and fiscal positions. As a result, their debt profiles are projected to be much more stable in coming years, and offer much better value than their developed market counterparts.
Flows into EM debt have begun to reflect this reality, and we have seen nice gains in our position, which has focused on dollar-denominated debt. However, with these dollar-denominated bonds making all-time highs, the trade has gotten somewhat crowded, and we felt it was prudent to take profits. Local currency EM debt has lagged to some extent as many dollar-based investors have not wanted to take on foreign exchange risk.
Fundamentals are beginning to shift in favor of local currency debt as well. With high unemployment persisting in much of the developed world, central banks have begun to pursue a path of competitive devaluation as they seek to weaken their currencies to help boost exports. With the Fed, BOJ and BOE aggressively easing, the ECB, whose political structure does not easily lend itself to aggressive asset purchases, is the last holdout of the major central banks. With German exports extremely weak, we expect Germany to give in and allow for unsterilized asset purchases by the ECB.
On the other hand, economic growth in most emerging market economies is much stronger, and they do not face the threat of deflation. As a result, most emerging market countries are unlikely to pursue the same type of monetary easing. Instead, they will prefer to see their currencies appreciate rather than risk rising inflation. As result, we now prefer local currency bonds to dollar-denominated bonds.
On a related note, Chile is a particularly bright spot in the global economy. We’ve preferred Latin America over most other EM equities (and our emerging market consumer position is heavily weighted to Latin America) for several reasons. First of all, most Latin American countries have fairly strong economic ties to the US, which has been one of the few bright spots in the developed world. Furthermore, Latin American banking systems are some of the most stable of all EM, and are least exposed to the ongoing European banking crisis.
Within Latin America, Chile stands out both for its strong economic growth and low inflation. Inflation is currently running below 2%, with real GDP growth running at about 5%. Despite this, Chilean equities have been fairly weak, and are well below their 2010 highs. We
attribute this in large part to weakness in China, Chile’s number one trade partner.
Chinese data has been much better recently, and it appears they have managed to engineer a “soft landing.” To be sure, China is far from out of the woods and still has a significant property bubble to deal with, as anyone who watched Sunday’s 60 Minutes can attest to. But their current policy of restricting loans rather than raising interest rates appears promising. In this way, they may be able to stem flows into their property
market without bankrupting current borrowers by raising interest rates.
If we are correct that China will be able to maintain a steady (albeit somewhat slower) growth trajectory of 7%, it will be very positive for Chile, especially for their copper exporters. On the other hand, Chile’s growth prospects aren’t completely wedded to China, and would likely maintain strong growth even in the face of a deeper slowdown in China.
Lastly, many people don’t realize how strong Chile’s free market policies are. Such policies are especially rare for a resource-rich emerging market country. When it comes to regulatory policy, trade policy, and the rule of law, few countries have Chile beat, as demonstrated by its high ranking in the Heritage
Foundation’s Index of Economic Freedom.
Please email us your comments, questions, etc.
John Forlines III and Court Hoover