Emerging-market debt or equity? Exploring a tale of two markets

With more than half of 2017 now in the books, it has in many ways been a year of two competing forces.

On one side, fundamentals throughout the global economy have been quietly, steadily improving, with data in the United States looking increasingly solid and with Europe appearing to have turned a corner as well. On the other side, headline risks throughout global markets have largely contributed to a sense of mounting unease, heightened policy uncertainty, and increasing political risk. In an unusual twist, however, many of these headline and policy risks have been originating in developed markets; emerging markets, these days, appear relatively benign.

That’s not to say that emerging markets are immune to potential changes in investor sentiment or to capital flight, but with stretched valuations in much of the developed world, many investors are taking a closer look at how to work exposure to emerging markets into their portfolios. Year to date through the end of June, emerging-market equities (EME) recorded gains of more than 18%, while emerging-market debt (EMD) posted gains of more than 6%, making each among the top-performing segments within their respective asset classes.¹ The return potential, however, is rarely the issue investors grapple with when thinking about an allocation to emerging markets—their focus is on managing risk exposure. On that front, these two asset classes have some important differences.

It’s a basic investment principle that debt instruments tend to be less volatile than equities, and that’s as true within emerging markets as it is in the developed world. Over the past decade, EMD has recorded a standard deviation (a common measure of risk) of roughly 8%, versus a much higher 23% for EME. One would expect—rightly so—that with that kind of higher potential for risk, EME would also offer meaningfully higher returns.

Recently, that hasn’t been the case. The annual returns for EME over the past decade have been less than 3%, versus more than 7% for EMD. It’s been a tough decade for global stocks in general, and during the course of the past 10 years, EME endured significant losses in 2015, 2011, and 2008. Meanwhile, the biggest gains since 2008 have been correlated with those markets that deployed the most aggressive quantitative easing programs; those stimulative measures have essentially been a developed-market phenomenon.

While the performance of both EME and EMD is dependent to some extent on the ability of emerging markets to realize solid economic growth, debt investors have a built-in advantage: They get paid interest while waiting for that growth to fully materialize. At a time when global economic growth appears to be picking up speed—but with many potential potholes to be avoided—investors would be wise to consider how much of a risk of an economic setback they’re able to tolerate.

It’s also true that currency fluctuations have a far greater influence on EME than on debt. Roughly 14% of all EMD is issued in non-local currency, the majority of which is denominated in U.S. dollars, while all EME investments have embedded local currency exposure risk.² Over the past five years, the U.S. dollar has strengthened significantly against a number of emerging-market currencies while only recently beginning to give back some of those gains. So-called hard currency EMD—that is, for U.S. investors, debt denominated in U.S. dollars—offers a built-in buffer to what's been a headwind in recent years for many investments with foreign currency exposure.

Ultimately, EMD’s reputation as an asset class reserved exclusively for the adventurous at heart is outdated. Today, more than half of all EMD is rated investment grade and, with a 0.58 correlation to the Bloomberg Barclays U.S. Aggregate Bond Index, the asset class offers diversification benefits to a domestically focused portfolio.³ The bottom line is that with low yields, low growth, and stretched valuations throughout developed markets, EMD may represent an attractive addition to portfolios, even for risk-wary investors.

1 Emerging-market debt is represented by the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Index, a market-capitalization-weighted index that tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities. Emerging-market equities are represented by the MSCI Emerging Markets Index, which tracks the performance of publicly traded large- and mid-cap emerging-market stocks. The Bloomberg Barclays U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest directly in an index. Past performance does not guarantee future results. 2 "Global Debt Monitor," Institute of International Finance, as of June 2017. 3 Manulife Investment Management, J.P. Morgan, as of June 2017.