Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name is Stewart Foley, I’ll be your host. Welcome back. We’re very happy to have you. And today’s topic is the EMification of DM and we’re joined by Pete Kent who’s a Portfolio Manager and Co-head of Emerging Market Fixed Income at Ninety One. Pete, thanks for taking the time. Thanks for being on today.
Peter: Thanks so much for having me. Looking forward to it.
Stewart: We’re thrilled to have you. We’ve got a lot to cover. I want to get right into it. If I may, what’s the town you grew up in? What was your first job of any kind and a fun fact?
Peter: Okay, so easy to start. I grew up in Johannesburg, South Africa until I was about 18, then went to Cape Town to study at university and then ended up in the UK and back in Cape Town, South Africa. So that’s the chronology of my geography. Serving Cokes at a school festival was my first job. My first paid job was as an auditor for Deloitte.
Stewart: Very nice. And what’s a fun fact?
Peter: A fun fact is when I eventually give up this game of bond investing, I’ll probably end up a game ranger in the middle of nowhere.
Stewart: Really? I love that. That’s so cool. All right, so we’re here to talk about EM and I think that the first question really gets at the crux of it, right? Can you talk a little bit about EM misconceptions and why you put this paper together?
Peter: I’ve been a bond investor now for over 20 years and the first half of that was trading developed market rates, trading euros, sterling dollar rates. And the second half has been as an EM bond investor. And I think EM gets a rough ride, especially when we think about the last 18 months.
So I’ve been sitting at my desk the last 18 months looking at some breathtaking moves in the developed markets thinking about the UK and last year with Liz Truss who unfunded dash for growth when they sort of extended the budget and we had a massive sort of gilt crisis. When I think about the Bank of Japan and the monetary policy they’re doing and what it’s done to the yen, these are the kind of moves that I think any emerging market would be super proud of. And what started to irritate me a little bit was when I chat to clients, when I chat to other investors, EM generally I would say the three points of feedback is ‘EM is a perennial underperformer’, ‘EM’S not worth the risk’ and ‘it’s kind of a backwater of politics’ and policy and those are the three sort of common things I hear a lot.
And when I was looking at the developed markets over the last 18 months or so, I just thought that was, I would say a little bit unfair and I wanted to set the record straight. That was the sort of primary thing. And I think important for me was to come at it from a perspective where I wasn’t selling the EM asset class. I think a lot of people got caught short selling the EM asset class just before the taper tantrum in 2012, 13. So I didn’t want to be disingenuous. The whole idea was sort of an honest assessment of where EM is, where DM is and to get EM a place at the investor table. That was kind of the thinking behind it.
Stewart: Yeah, I love this that EM would be proud of in DM. Can you give us some examples?
Peter: So I’ve got three, but I’ve actually got four. The fourth one’s probably a little bit close to home for the US audience. Probably a little bit provocative, but I think I’m going to save that one. No, I’m definitely going to mention it but it’s going to be last in my list, everyone.
Stewart: Yeah, you got it. You got to mention it. Anything controversial, we love that. Let’s do it.
Peter: Well I think imagine this, right? Imagine you’re sitting at your Bloomberg terminal or you’re reading something or you’re listening to a podcast and you don’t quite know the axes of the graph that people are looking at or talking about and you set up the graph as excessively loose monetary policy results in a 50% depreciation against the US dollar. I mean your audience are going to go, oh easy, that’s EM, that’s Turkish lira or rand or something like that. But you know what was, that was the Japanese yen, right? And that’s yield curve control in the face of inflation and record hikes in other developed markets, the yen got slammed and EM FX outperformed it last year. The second example is one particularly close to my heart because I used to trade gilts and I remember September last year when Liz Truss and Kwasi Kwarteng did that unfunded dash for growth, they essentially cut taxes and they went hell for leather and gilts just hit an air pocket and it blew up the liability-driven pension system in the UK.
The Bank of England eventually had to intervene. That was a 60% to 70% devaluation in longer-dated gilts. And if you overlaid the dollar on that, so that was 60% to 70% in pounds, if you looked at it in dollars it was even more because the pound also got beaten up. So the first thing when I saw that last September was thank goodness I don’t trade gilts anymore because that’s the most brutal move I’ve ever seen in my career. And second of all that is something that is really constrained to Argentina, those kinds of things. And I don’t think people realized the magnitude of what was happening. That was the second example.
The third example was Silicon Valley Bank. I remember looking at two-year notes, the most liquid instrument globally, the global risk-free rate. I remember looking at the tick sizes in the two-year note around Silicon Valley Bank. That thing was ticking on the screens at two to four basis points a time, which just showed that the market debt wasn’t there. That’s the kind of bid offer that South African government bonds would be proud of.
And then the last one, the provocative one, when I did the paper, the whole debt ceiling debate was raging on your shores and you saw in sort of front debted CDS, you could see the premium that was getting built into US CDS as sort of tricky that that metric is that CDS, we all know the sort of limitations US CDS has as a sort of metric, but the premium that was being built into that market, if you’d put the headline that of imminent default resulting in flattening of CDS curve, that would’ve absolutely been an emerging market headline.
So there’s been a few examples over the last 18 months which really could have been something EM and that’s where EMification of DM came in. I’m not talking economically, I’m not saying the economies are kind of like converging, but I’m saying market characteristics, volatility, return expectations, they’re all converging and there’s this blurred line between EM and DM and that’s the name EMification of DM.
Stewart: Is there any possible explanation that some of that volitility in DM is a result of a lack of liquidity in markets? I mean I’ve heard illiquidity brought up many times on podcasts and in conversations with CIOs. Is there less liquidity in DM that’s resulting in some of these moves or is it something else?
Peter: I think the answer to that is yes, but I think that’s part of it. And now we’re going to kind of hark back to my previous career. I traded, for my sins, I traded close to a decade at Goldman Sachs.
Stewart: For my sins! That’s amazing.
Peter: No, it was an amazing formative part of my career. I did it through the global financial crisis. So I was at the coalface and that’s kind of why I feel I’ve got a little bit of credibility to chat about this particular subject because of that. So I think part of it is liquidity and I’ll get to that in a sec. I think the other part is, and I’m not a central bank basher by any means, I love the Fed. I think they’re the best central bank in the world in all honesty, but there was definitely a policy error that happened in the developed markets. So when inflation turned up in developed markets, they called it transitory and when it turned up in emerging markets, they didn’t have the luxury to call it transitory, they just got cracking. So I think central banks were starting six months late at a minimum in developed markets.
So they had a lot of catch-up to do. I think that led to some of the volatility. So there was no doubt there was a policy mix there and the sort of fiscal easing that you saw around the time was unprecedented. So there was definitely a policy element to the volatility which not all of it will repeat, but some of it will likely repeat. I think when we think about the next decade, we can chat about that later. But I don’t think all of that volatility repeats but a decent chunk stays. But then on the liquidity point, I think this is a great point. I used to make markets for clients for euro sterling dollar rates and pre-GFC, banks were allowed to have a large balance sheet and we could intermediate flow. So we could kind of sit there between different clients and essentially dampen the effect of price action and volatility.
Post GFC that ability to warehouse risk on sort of banks’ balance sheets has declined. The system is probably stronger for it because of less systemically important banks. But I think market liquidity is one of the collateral damages. I think banks and other balance sheets’ ability to warehouse risk and sort of dampen these moves is definitely a feature. So the fact that you don’t have someone intermediating the flow essentially calms things down, I think, so it’s a market microstructure point, something that I used to know very, very well. I definitely think the market microstructure makes these kind of gappy moves more prevalent. So I do think liquidity is part of it, yes, and I think it’s down to the fact that you don’t have anyone intermediating flows anymore.
Stewart: That’s really interesting. And so you had mentioned returns, can you talk a little bit about returns over the last two decades, EM versus DM?
Peter: When you do look at returns, those sort of three points that I raised in the beginning, there is some element of truth to it, right? There are a lot of people as I mentioned, who got into emerging markets around 2012, 13 because that emerging market debt had had a fantastic decade before that. You’d seen relative growth in emerging markets outstrip developed markets, which is just the perfect mix for emerging markets. You had a whole bunch of cheap money coming out of the GFC. So that was a fantastic mix for EM. And EM outperformed DM, I’m talking in fixed income space here, very handsomely in the decade before 2013. 2013 was the taper tantrum and that marks quite a big change and since then EM on average has underperformed and I think EM kind of got caught napping a little bit going into 2013. There was a lot of easy money around and if you recall there was that phrase, the Fragile Five, back then.
So EMs in general were quite imbalanced from an external flow perspective and the next decade’s returns have been disappointing. And I mentioned earlier I was a little bit irritated with the feedback the asset class gets, but it’s not entirely unwarranted. There has been a disappointing decade, but I think when you look at what’s happened in the EM the last couple of years, something interesting is happening. You had last year all of these developed market currencies getting really beaten up by the dollar, yen, sterling, euro. EM FX generally outperformed those currencies.
If you look at EM FX in aggregate versus the dollar last year, EM FX outperformed the other trade weighted partners and EM bonds in local currency also outperformed treasuries and a lot of more risk-free type defensive bonds. So something has definitely started to change the last two years or so. So thinking about returns, I think there’s definitely two distinguishable decades of which 2013 marks a watershed, but the last couple of years have noticed that EM has started to behave differently as a diversifier. And if you came down from Mars and looked at what you threw at EM over the last couple of years, you would’ve been very surprised by its relative outperformance. And that’s part of why this whole thing, just kind of watching the screens for a couple of years, seeing the data, it started to sort of sneak up on you that something different was happening.
Stewart: And so it would be helpful I think to talk about some of the things that you mentioned that were thrown at EM. I want to make sure that our audience recognizes what those things are. And then the second part of it is, again, I’m not trying to sell EM either, but what’s behind the EM performance of late?
Peter: So again, I like the ‘come down from Mars’ test. If you came down from Mars and saw that we had the Covid shock and there was a huge global competition for capital, competition for medication, EM was at the back of the line for all of that. You had food price shocks, you had oil price shocks, EM generally importers of food and oil. I know there are sort of disparities in different cases there, but normally food and oil, those are real problems. I mean real problems for EM.
You had the fastest Fed hiking cycle since the eighties, again, not an environment that EM runs into and enjoys, and then you had a Russian invasion and default. So that is really not a sequence of events that should result in emerging markets outperforming. So I’m not denying that emerging markets had a red year last year and our clients can’t eat negative years and they can’t eat positive alpha in a negative year. But what’s important is the relative performance of emerging markets in the context of those kind of events. That’s what really started us thinking. And then there was this intersect of the volatility that was experiencing and you kind of realized that there was a blurring of lines happening.
Stewart: That’s really helpful, Pete, and I appreciate the explanation and I really like that ‘come down from Mars’ test because I’ve been at this a minute and I think that people tend like me drag this legacy view of EM and not really one that’s informed by the latest facts, just the latest data that’s available. One of the things I think that’s an important point is you mentioned the volatility in DM, in the developed markets, what can you tell us about that?
Peter: So volatility is a key piece to this, right? So if you think about what I said in the intro was there was a hunch and the hunch was based on looking at the screens. That hunch started to gather momentum as we looked at the relative EM performance in what should have been a tough year for EM. And when we looked at the causal factors, EM was essentially behaving orthodox. EM had essentially got their ducks in a row post temper tantrum. So what you were seeing in EM wasn’t just a fluke, it was something happening. So you’ve got the hunch, you’ve got the relative performance, how do you now get the numbers to test what you’re thinking? And volatility was a key component. Return was a key component. So I’ve spoken about the return now the vol was super interesting because when you looked at the volatility of the emerging market local index, it’s a high vol series, the volatility there sits between 10% to 15%.
It’s kind of just short of equities, it’s unhedged, you’re exposed to EM local currencies, not only bonds. So it’s a volatile series. That’s what people expect. What you notice when you look at the volatility and if you look at it on a sort of rolling one year, rolling three year, if you kind of look at it in any way, shape or form, again, one of the key tests to this whole piece of work was let’s not try and sell the product. Let’s just be objective here. So we looked at different timeframes to make sure there was a consistency to everything. And what you notice is EM from a vol perspective, if you look at vol in a distribution, it was behaving like it’s always behaved despite what was being thrown at it. So much so that when we looked at the numbers, I got our quantitative analyst to recheck them.
I’m like, “Jono, you’ve taken Russia out of these numbers, we can’t cheat here, we’ve got to have Russia in here.” And he is like, “Pete, Russia’s in.” So it was surprising how it was as volatile as it’s always been, but you couldn’t really see anything different. There wasn’t a new regime. Now if we ran the same analysis on developed market indices, so we started with Barclays Aggregate and Barclays Aggregate has got emerging markets in there. So we figured if we kind of showed that, which essentially shows a new vol regime the last couple of years. It’s not the same as EM, it’s in a regime of volatility it’s never been in before, admittedly lower than EM, but it’s broken out like it’s in a new vol regime. But then we figured our clients and everyone would say, “Well Barclays Agg has got some EM in there, you guys are cheating.”
So we took the EM out and we looked at purely DM, we looked at it on a hedge basis. So we didn’t even have FX volatility in there because we kind of were thinking about substitutes for our clients. Our clients think about EM unhedged and they think of DM hedged. So we looked at a DM hedged series and we looked at a bunch, we looked at US series, we looked at US Treasury series, we kind of looked at a bunch of DM series and all of them showed on a one and three-year horizon that developed market volatility was in a new regime. It was in a volatility regime it had never experienced before. It came close in some markets to the global financial crisis, but the majority of markets were in a new regime.
And that was really, really interesting to us because ultimately people think about, “Oh wow, these DM yields look amazing. Why should I go and move up the risk curve in emerging markets when Treasuries are offering me close to four and a half right now?” It’s because everyone is thinking of 4.5% in developed markets on the basis of volatility they’ve experienced in the last decade.
And the last decade has been a period where you’ve had unprecedented low economic inflation and bond market volatility. So thinking about a 4.5% yield in relation to the last decade of vol, dripping roast, tasty. But thinking about it in relation to the last two years and whether the last two years are more representative of the future, 4.5% ain’t enough. If you want to try and get the same Sharpe ratio that you’ve had over the last decade at current yields in developed markets on current volatility. So let me just break that down a little bit.
So if you take the current volatility and the current yield and you try and replicate the Sharpe ratio that you’ve got in developed markets over the last decade, developed markets need to rally something like two, three hundred basis points. You need a capital return, a significant capital return, to get you that Sharpe ratio.
If you did the same calculus to emerging markets. So if I’m going to get the same decade of returns, the same decade of volatility on the current yield, you don’t need any capital appreciation, the yield is perfect. Okay, but that’s not good enough. EM has been disappointing the last decade, DM has been fantastic. So if you kind of said, “Well, if I wanted from a risk return perspective over the next few years, if I want EM and DM to give me a Sharpe ratio that’s similar, that’s maybe not as good as the last decade for DM maybe a little bit better than the last decade for EM,” it’s interesting, the kind of capital uplift you need on current yields is similar, but the mix of return you require, in EM you get 2/3 of your return from income, you get 1/3 from capital. In DM you need as much capital return as you do from yield.
So it’s a little bit technical, a little bit in the weeds. The moral of the story is everyone thinks that DM yields right now are fantastic, but if you put a new vol regime in there, you’re going to need more income protection than you’ve needed over the last decade. So the key question then is, is the next decade going to be kind of like the last two years of volatility or is it going to be like the last decade of volatility? Because if it’s anything like the last two years, your valuation assumptions when you do your asset allocation will probably need a little bit of a scrub.
Stewart: That’s a really interesting way to look at it. If you say “I want the same Sharpe ratio I’ve had,” then 4.5% is not nearly enough. You’re talking about something more like 6.5%, 7%.
Peter: Precisely right.
Stewart: I mean I’m just doing the math based on what you went through and it’s a really good point because I think too, investors have recency bias. I think human beings have recency bias. And you go, “Wow, I mean treasuries have been at 2.5%, three for a long time and now it’s at 4.5%.” And you go, “That’s amazing. That’s a great buy.” You go, “Well wait a minute, let’s talk about the volatility,” because risk and return in the investment world is inextricably linked, right? And you’ve got to be thinking about the volatility when you’re doing that analysis, at least it seems to me.
Peter: Yeah, I think a lot of the sort of statistical basis for this analysis we did came from a chap I worked with and he manages an emerging market total return fund, which essentially tries to give you emerging market returns without the white-knuckle ride. Right. It tries to give you less vol and it tries to improve your Sharpe ratio from the denominator effectively, not from the numerator. So everyone’s trying to beat returns, but no one’s thinking, which I think is for the pros, reducing the denominator and keeping the returns the same, that almost feels like for the pros for me always sort of chasing the top line always feels like the wild ride side of things. So I definitely think the two are linked, but I do think we need to be objective here. So I think I’m getting close to salesy, so I just need to hold myself back a little bit.
There is a premise here that the volatility of the last two years is going to repeat for the next decade. And I think if I was holding myself to account, I think the last two years in developed markets for the reasons we spoke about has been unprecedented. We are probably going to hang on to quite a decent chunk of that volatility, but not all of it. And I think when we think about the next decade, the last two years is probably not going to repeat. So perhaps I’m handicapping DM yields a little bit too much by saying that the last two years will repeat, but jeepers, I certainly don’t think we’re in the last decade. I do think you need to think about the next 10 years and what developed market bonds are going to do from a volatility perspective, they’re not the last decade’s bonds.
So wrapping up this whole piece of work and trying to be objective about it is we’ve had a period post the global financial crisis where balance sheets were repressed. We kind of touched on it from a liquidity perspective, as a result of that nominal growth was in short supply, inflation was low. So whenever there was a global problem, central banks could throw money at the problem and that turned up in developed market bonds, developed market credit in very little volatility through asset purchases. Are we going to get that for the next decade? The next decade we think we’re going to see a whole rewiring of global supply chains, whether it’s tensions with China, whether it’s Covid, whether it’s fringe, whatever reason it is, people are going to rewire the supply chain, that’s going to require physical investment.
We’re going to see an increase in defense spending. There’s been a huge wake-up call the last couple of years. There’s going to be a green energy investment. So there’s going to be a whole bunch more investment than we’ve had over the last 10 years. That’s going to result in greater nominal growth, greater inflation volatility. Central banks aren’t going to be able to turn up every time there’s a hiccup. As a result of that, we do think there’s going to be more volatility. We do think asset classes are going to have to offer more premium. We think there’s going to be a geopolitical premium in there too. These are the kinds of things that emerging markets know. We’ve had a politics score for 30 years, right? This is new to the developed markets. Emerging markets have an inflation premium, it’s a risk premium product. So the next 10 years is essentially a world that emerging markets knows.
So DM we think will hang on to some of the volatility. EM will probably behave like it’s always behaved and it’s kind of set up for that from a valuation perspective. So in setting the record straight, what we generally say to people is, listen, we get it. EM is a volatile asset class. It’s cyclical, it has its own bottom-up stories. You probably don’t want to allocate to it in aggregate. You probably need someone to help you pick the doozies from the good ones. But what it is, it’s diversifying. It has behaved defensively, it’s got premium in it, it’s kind of set up for the future. DM is probably more defensive. We get it and it’s probably a core allocation, but please, let’s put emerging markets at the global investor table and let’s debunk those three things that I spoke about right at the beginning.
Stewart: That’s fantastic. I’ve learned a lot and I love that. Always. So I got a fun one for you out the door you can take, either or both. Don’t feel any pressure. Lots of our guests have taken both.
Peter: I got to concentrate for this one.
Stewart: Ready? All right, the best piece of advice you’ve ever gotten and/or who would you most like to go to lunch with, alive or dead?
Peter: Best piece of advice I ever got, and I’m going to loop to the career point here, was my first boss at Goldman Sachs when I turned up and my phone was four foot wide and I got completely freaked out by what was in front of me and he said, “Pete, when you’re in this seat, you know more about Euro swaps than any person on this planet. That is your job.” And I give that advice to anyone who starts in a seat around me. Whatever your domain is, you need to be the best person in the world for that domain. That’s the level of knowledge you need. So that was a piece of advice that stuck with me. The person I would dine with no doubt would be Nelson Mandela.
Stewart: Oh, outstanding. Nelson Mandela is the second time that that name has been brought up. That’s really cool. I’ve had a great time today and learned a lot. I really appreciate you being on, Pete. Thank you so much.
Peter: Yeah, thanks for having me. I’ve had a whole bunch of fun. I really appreciate it.
Stewart: My pleasure. We’ve been joined by Pete Kent, who’s the portfolio manager and co-head of Emerging Market Fixed Income at Ninety One. Thanks for listening. If you have ideas for a podcast, please shoot me a note at firstname.lastname@example.org. Please rate us like us, review us at Apple Podcasts, Spotify, Google Play, or wherever you get your favorite podcast shows. Thanks for listening. My name’s Stewart Foley and this is the InsuranceAUM.com Podcast.
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Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.