Regular readers of our Emerging Market (EM) Debt Strategy Quarterly will have noticed that we have been advocating the case for active beta management since late 2016. Whilst a superficial look at EM bond market returns would seem to suggest that investors continue to prefer beta strategies, we believe that there is growing evidence of a change in investor positioning.
The reasons for advocating this shift are by no means trivial. In fact, there are good arguments for staying long beta, perhaps most importantly the ongoing improvement of emerging market fundamentals. Most EM investors will be familiar with the typically quoted macroeconomic statistics such as increasing GDP growth, stable or improving current account balances, and decreasing fiscal deficits and inflation. In addition, better macro numbers are increasingly translating into improving bottom-up statistics such as upgrade / downgrade ratios, corporate leverage and earnings expectations. Furthermore, they lead to more favourable market technicals. For instance, smaller fiscal and current account deficits typically mean lower re-financing requirements for governments and corporates and consequently, less bond issuance. In sum, there are robust fundamental and technical reasons behind the on-going EM bond market rally since February 2016.
So why should investors care about active beta management at all? First, EM bond valuations are looking increasingly expensive with few exceptions. Our EM vs. DM valuation scoreboard (using 5-year Z scores) shows that EM FX vs. USD remains cheap and EMBIG HY vs. US HY and EM Rate marginally cheap; whilst all other sectors are either marginally or very expensive. So in contrast to fundamentals and technicals, valuations offer a much less attractive investment case for EM debt.
Second, we continue to see various risks that could adversely impact emerging markets debt. Perhaps the most important risk is US growth and the Fed’s monetary policy. In view of the ongoing economic recovery in the US, coupled with potential tax reductions, we believe the market consensus may be too complacent by pricing in only one interest rate hike in the remainder of 2017. The other major risk is politics. The market has taken the outcome of the constitutional referendum in Turkey in its stride, but the upcoming presidential election in France in April and May and general elections in Germany in September could potentially negatively affect appetite for EM debt. In short, taking into account these risks and the relatively expensive valuations of EM debt, the case for simple beta strategies appears much less attractive.
However, can we observe early signs of a shift in investor sentiment? Whilst fund flows tend to be a concurrent indicator, we nevertheless believe that they offer a meaningful guidance to investor sentiment. The chart below shows all flows to dedicated EM debt funds and ETFs since the beginning of 2016, as calculated by the GFICC Quantitative Research team. Not surprisingly, ETFs have been capturing the bulk of flows in the past 15 months. In fact, ETF flows turned positive in March 2016 and have been dominating overall EMD flows since then.
That being said, we have been observing two periods of open-ended funds capturing market share from ETFs. The first was in September-October 2016, ahead of the US presidential election, and more recently in 2017. Indeed, the latter started before the March rate hike by the Fed and has continued since then. And in both instances it could be argued that investors were preparing for potential risk events.
The breakdown by sub-asset class shows significant differences between the various strategies. The picture for EM sovereign strategies more or less mirrors the aggregate, which is not surprising given that this strategy dominates the market for dedicated EMD ETFs. EM sovereign ETFs have been attracting the biggest inflows of all EMD strategies, but open-ended funds have been gradually gaining market share since late December 2016.
The picture for EM local currency strategies is more dramatic, given that ETFs captured more or less all inflows since 2016 while open-ended funds continued to suffer outflows. Corporate strategies show the almost opposite picture, with almost all flows being captured by open-ended funds and ETFs only a relatively small amount.
We would refrain from reading too much into this as flows to local currency and corporate open-ended funds and ETFs are more driven by strategy-specific factors than beta vs. alpha considerations. Nevertheless, we can observe renewed demand for actively managed open-ended funds since the beginning of this year, which lends support to our view that investors are increasingly looking for active beta management.
We also looked at average market betas for any signs of a shift in investor sentiment. Similar to fund flows, average market betas should be taken with a note of caution as they are concurrent indicators. Nevertheless, significant changes in market betas can provide a meaningful indication of investor sentiment.
The chart below shows average betas for the three main EMD market indices. All three are lower than in December last year and two have further decreased since February 2017. The average beta for EM corporate (CEMBI) appears to have taken the biggest decrease, falling to its lowest level in the last two years, whilst EM local currency debt (GBI-EM) has fallen close to the recent lows in mid-2016. EM sovereign (EMBIG) has actually seen the biggest fluctuation, decreasing sharply in January-February but climbing to year-to-date highs in April.
Perhaps most interestingly, EMBIG and CEMBI betas seem to have become de-synchronized and whilst that might not necessarily suggest a major shift towards alpha strategies, it still signals that investors differentiate more between the various EMD sectors than in 2016.
Whilst dedicated EMD strategies have continued to attract inflows since February 2016, actively managed open-ended funds have been able to gain a growing share of these flows since the beginning of this year. At the same time, average market betas of dedicated EMD are lower than in 2016, which means that on balance, investors have increased allocations to EMD whilst trimming traditional market beta exposure. The outlook for EM debt remains supported by improving fundamentals and robust technicals, but expensive valuations and latent developed market risks further strengthen the case for active beta management.