Skip to content

Emerging Markets – Stocks OR Bonds. Revisited.


There have been several comments to my Sept 2 blog post ‘Emerging Markets – Stocks OR Bonds. Not Both’.

It was poorly written. My apologies. A clarifying response is appropriate.

The EM blog was written in response to two ‘sales pitches’ from two leading (and unnamed) Investment Managers. Their premise was that opportunities exist for both EM Bonds AND EM Stocks – at the same time. The impression one was left with was ‘we don’t care what you buy, just buy’.  A.k.a. ‘If you’re going to buy, buy. If you’re not going to buy, then, bye, bye.’

The business case for EM Stocks (faster economic growth versus developed markets) and EM Bonds (higher yields) may be valid. However, Investors hypnotized by the lure of EM Bond yields may wish to consider deeper analysis.

First, the economic scenarios under which both EM Bonds and EM Stocks outperform at the same time eventually become mutually exclusive. Either EM Bonds or EM Stocks must correct. As we see year-to-date:

Year-to-Aug 31/11 1 Year 3 Year
Emerging Markets bonds  (proxy: iShares.ca EMB)

7.75%

7.2%

10.72%

Emerging Markets stocks (proxy: iShares.ca EEM)

-8.55%

18.88%

5.05%

This was articulated in a BCA Research flash a year ago.

‘a simultaneous rally in … emerging market equities and domestic bonds is unlikely to persist.’

‘If emerging market economic growth stays strong (i.e. stock prices move higher), then the bull market in EM domestic bonds will need to reverse, i.e., both the real interest rate and inflation expectations will have to rise. By contrast, the bond market rally will be sustained only if growth slows and inflation expectations stabilize/drop. This will most likely occur in an environment of … slower growth, an outcome that would be consistent with weaker share prices. That is to say, a relapse in one … of the markets –emerging market stocks and domestic bonds – is inevitable.’

The BCA scenario is playing out.

Second, negative correlation is the holy grail of portfolio management. No doubt. An investor wants the EM Bond zig to the EM Stocks zag. But both EM Bonds and EM Stocks are being ‘sold’ as if the investor should expect continued performance from both at the same time. As if the correlation were +1. That was the case over the last 1 year and 3 year time periods. This could not and cannot persist. Again, the economic scenarios are mutually exclusive. The 1 and 3 year returns are an anomaly. More recent results show negative correlation working closer to theory. Again, see previous blog post. Investors should expect more EM Bond zig to EM Stock zag going forward.

Year-to-Aug 31/11 1 Year 3 Year
Emerging Markets bonds  (proxy: iShares.ca EMB)

7.75%

7.2%

10.72%

Emerging Markets stocks (proxy: iShares.ca EEM)

-8.55%

18.88%

5.05%

Third, foreign bonds, for Institutional Investors at least, are more often seen as a tactical play versus a strategic positioning. See PIAC average Pension fund allocation. Foreign bonds are 1.76% of the asset allocation pie. As a tactical play, timing (entry and exit) becomes a factor that a few Institutional Pension Plans and a few Investments Managers may be equipped to manage. Many are not. Surely, most Individual Investors are also ill-equipped to manage this type of market timing task.

Fourth, Investors often neglect the foreign exchange / currency effect. EM currencies have been strong. True. Strong currencies are bad for trade, exports and continued growth. There is potential for some EM currencies to devalue as they struggle to ‘keep’ growing.

Fifth, one question to ask is what is the purpose of foreign bonds in a portfolio? Is it for yield, or is it to assume interest rate risk, gain sovereign credit risk exposure … all this AND currency risk? Again, Investors chasing yield while neglecting currency risk risk a bad case of whiplash. Introducing foreign bonds into the portfolio mix can introduce a whole new risk & return dimension that is, perhaps, unintentional – especially on the risk side.

Sixth, it’s always easier to put your money in than it is to get your money out.

“The value of bonds outstanding in the region’s domestic bond markets reached $5.2 trillion at the end of 2010, representing an 18.3 percent gain from a year earlier and a threefold increase from five years earlier,”
“The flood of cash rushing into local markets hasn’t been lost on some regional governments, which have posted barriers and regulations aimed at stemming cross-border capital flows and dampening currency appreciation, even as they raise interest rates. In recent months the Indonesian central bank stopped auctioning three-month paper, and started auctioning nine- and 12-month paper, while imposing a minimum 28-day holding period. In October, Thailand reinstated a 15 percent withholding tax on capital gains and interest income on foreign holdings of domestic government, state enterprise and central bank bonds. The following month South Korea announced it was reinstating a withholding tax on foreign investment in local bonds, sparking a sell-off of foreign-held treasury bonds at the end of last year.” From Institutional Investor magazine.

And so, Emerging Markets: ‘Your strength will become your weakness’ –The Art of War.

To ‘sell’ EM Bonds AND EM Stocks as if they can be expected to perform at the same time going forward is still, I think, bad advice.

Next time?
More Risk management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
Advertisements
No comments yet

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: