Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Steve Ellis, Manager of the Fidelity Emerging Market Debt Fund.
Steve Ellis: Hi, Emma.
Wall: So, year-to-date, emerging market debt has done very well. What has driven those positive returns?
Ellis: Well, you're right. The returns have been very strong year-to-date. In local currency, returns have been around about 13.5% and in hard currency, the returns have been about 7.5%. The returns have actually come from a number of factors, I think.
I think the first one is that there's a big yield search taking place in the global economy right now. So, when you look at hard currency debt, for instance, we have seen some spread compression taking place in markets. So, debt spreads have actually tightened to about 300 basis points over U.S. treasuries. But the bulk of the returns are coming from the yield that you get on the asset class which is about 5%.
In local currency, it's a similar kind of story. The yield search has been very pronounced in that asset class and the returns are being basically generated from the yield of 6% on local currency debt, but also and I think more importantly, it's been a very weak dollar which has generated returns of about 9%.
So, all-in-all, I think returns have been strong. But I think overlaying this whole thing has been a cyclical improvement in growth in emerging market debt. So, we have seen real yields higher; we have seen an improvement in the balance payments. So, this sort of structural side of emerging markets has improved, but the growth dynamics have improved as well.
Wall: And the search for yield goes on. U.K. investors are only too aware of that. Does that mean that the asset class is going to continue to do well because there is still that demand?
Ellis: Well, I think it's going to be hard to replicate the strong returns that we've seen in the first half of this year. I mean, ultimately, it's going to boil down to a few factors. I think the first one is whether the weak dollar trend can actually continue. And I have my doubts actually.
I think that in a look at what's priced in now to the Fed funds future curve, which can really drive the dollar, the market has priced out a lot of Fed rate hikes. So, if you look between now and the end of 2018, there's only 30 basis points of hikes priced in. So, that could easily be moved higher if the Fed do actually embark on a more aggressive tightening phase, the tightened financial conditions.
I think one of the things that caused this cyclical improvement in growth has been China and it has caused spreads to tighten, currencies to rally and so on, particularly the commodity currencies. And I think that it's going to be very hard for China to replicate the strong growth that we've seen in the first half because one of the most important trends in China at the moment is we've seen a very sharp decline, a contraction, in fact, of the credit impulse there, which means the change in credit as a percentage of GDP is actually now tightening as the authorities there try to get to grips with the debt issues that it has. So, I think the mixture of weaker growth and also the potential for the market to price a slightly higher rate of tightening by the Fed could actually weigh on the asset class a bit.
Wall: So, more muted expectations for the remainder of the year. However, will the markets that have done well so far this year continue to provide those opportunities? Or are you looking elsewhere for the best value opportunities for the fund?
Ellis: Well, the markets that have performed the best in the first half of the year have been the more commodity resource-based countries and that's really a function of this big improvement in growth that we saw in the tail end of last year and into this year and that in itself came from China. So, China last year turned the taps on in a fairly amazing style where it's generated about $4 trillion worth of credit expansion, which is about just over 40% of GDP. And so, we saw a massive surge in import demand from China. So, imports in China rose about 26% year-on-year into the end of last year and into the start of this year. And that lifted all boats in emerging markets. So, all the commodity currencies, all the commodity credits, performed the best.
But like I said, I think the more likely scenario for the second half and certainly, going after the Chinese plenum in November is one where the authorities have to do something to get to grips with the explosion in debt that we've seen. So, I think from that point of view, it's very difficult to see those commodity resource-based countries replicating the strong returns that we've seen. And I think this is an environment where safety really counts in emerging markets that you need to actually be – you could still generate the yield by finding some of the yield plays but looking a bit more at quality, trying to find some assets which just are more defensive from that respect.
Wall: Steve, thank you very much.
Ellis: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
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