With the dynamics of global growth and risk changing rapidly, it is time for investors to reorient their thinking about global bond allocations and the investment strategies that drive them.
The global financial crisis has been both wider and deeper than anyone could have predicted. But perhaps even more surprising than its magnitude has been the enormous realignment within the global economy and financial markets that the crisis has brought to light. Many emerging economies not only felt less pain than many of the world’s advanced economies, but they were also among the first to rebound post-crisis. This experience stands in stark contrast to past crises when, as the saying went, if the developed world sneezed, the emerging world caught pneumonia. It also highlights the incredible progress many emerging countries have made in reducing their vulnerability to changes in sentiment – a vulnerability that in the past led to self-fulfilling crises of confidence. But given the rapidly evolving nature of credit quality and risk in today’s world, historical definitions of sovereign credit quality can no longer be readily relied on. Indeed, by many measures, the lines between “developed” and “emerging” market economies have blurred so much that it’s difficult to clearly delineate the two groups.
These blurring lines have important implications for portfolio construction, in particular the need to:
- take a more holistic approach to global bond investing
- reconsider the benchmarks that drive strategic allocations
- increase flexibility in order to quickly adapt in a rapidly evolving world
Not all debtors are equal
Perhaps the most important development that the crisis brought to the fore is the large, rapid buildup of debt in developed markets (DM), as shown in Figure 1. But while it is generally true that developed nations now carry much higher debt burdens than their emerging market (EM) peers, it’s also true that developed nations have a longer history of debt sustainability.
When evaluating the likelihood that any debtor will repay a debt, it’s important to look at both its ability and its willingness to repay. Historically, developed markets have rarely been questioned on either – their large, vibrant economies and predictable management of public finances ensured their ability, while stable institutional structures and history of repayment suggested a strong willingness to make good on the debt. Emerging countries, by contrast, have historically been forced to pay high rates of interest as markets questioned their ability and/or willingness to repay.
Today, the situation appears to have switched. Many developed markets are expected to have trouble growing the GDP that is the basis for servicing their debt, while many EM countries have emerged from the crisis with much more stable public finances. But the defining line of debt sustainability cannot be simply redrawn between developed and emerging markets. Certainly, the eurozone offers the clearest example that simplistic definitions of creditworthiness may no longer apply.
It is also important not to overlook the potential benefits of issuing debt in domestic currency. The fact that the U.S. and many other developed markets issue debt in a currency they themselves can print enhances their ability to repay. This option isn’t available to ailing eurozone countries. As for emerging nations, many still need to consistently attract foreign currency to repay their foreign- currency-denominated debt, but others, such as Brazil and Mexico, now borrow mainly in their own domestic currencies. Thus, it’s important to understand all of the fundamental underpinnings for a country’s debt, including the specific dynamics of the currency in which the debt is issued.
Vital signs: Population growth
Demographics is another area where the lines between developed and developing nations are not quite so clear. Aging populations in many developed countries represent a significant headwind to sustained growth, and indeed are one of the reasons growth rates are expected to slow. Japan now has the oldest population in the world and faces a steadily declining working age population. In contrast, Brazil has a low median age combined with a large and growing working age population. Does the Brazil-Japan comparison mean that EM nations have a better demographic foundation compared with DM nations? Not necessarily. China, whose one-child policy has stunted birth rates over the past few decades, faces a demographic challenge not unlike that of Japan. Conversely, the demographic outlook of the U.S. is surprisingly supportive as a vibrant immigrant population and high birth rate are expected to increase the working age population in the years ahead.
Reserves: Signals of both strength and weakness
Examining a country’s international reserves also reveals a more nuanced picture. In the last decade, many EM countries have successfully built up huge reserves, as Figure 2 illustrates. By saving a large portion of the foreign currencies brought onshore through capital investments and trade flows, they now have a historic level of financial flexibility. But these foreign exchange reserves act as a hedge in the event of a sudden stop in foreign capital flows – so they are more a necessity than a choice, a sign of both future resilience and past vulnerabilities.
So what should markets make of the fact that developed country reserves are only a fraction of those held by emerging countries? While owning reserves has become a source of strength for many EM countries, being the reserves may be the greatest strength of the developed world. An internationally held, liquid currency and the consequent ability of a central bank to expand its balance sheet are the priceless privileges of a select few. Because of the U.S. dollar’s status as the “world’s reserve currency,” the U.S. not only doesn’t need to maintain reserves, it can also provide a crucial store of value for others in times of crisis.
Political winds of change
Traditionally, political risk was associated with emerging countries that faced abrupt regime changes and sometimes even violent coups. This type of political risk remains today, as evidenced by the demand for political representation in the Middle East recently. But as the call for political change broadens among various global populations, political risk distinctions are no longer as clear.
First, with democracy gaining a larger global foothold, political risk has diminished for many emerging nations. In Mexico, for example – a country where two out of three parties still have the word “revolution” in their name – the outcome of this year’s contentious presidential election was not expected to derail or materially change the country’s fiscal or economic outlook. Conversely, elections in France and Germany are expected to gradually, but decidedly, change Europe’s outlook, and the election stalemate in Greece earlier this year had the potential to disrupt the entire eurozone. The situation is changing in the U.S. as well, where the 2011 “debt debacle” and sluggish pace of growth have created deeper polarization between political parties – a political risk that led to S&P’s downgrading of the U.S. credit rating that August. As a result, the potential for political changes to materially impact sovereign creditworthiness can no longer be simply defined along EM and DM lines.
While both rating agencies and general perceptions have been slow to embrace these realignments, the markets have adjusted quickly to the transformations in economic growth and credit quality.
Market valuations of sovereign credit quality are now less defined by the terms “emerging” and “developed,” and more focused on an assessment of each country’s underlying credit quality. Credit default swap spreads, for instance, which widen with investors’ views of higher default risk, show the market’s integration of EM and DM sovereigns within a larger credit spectrum, as illustrated in Figure 3.
Navigating a realigning world
In a world where the demographic, financial and political lines separating developed and emerging countries are increasingly blurred, we believe bond investors will need to adapt if they hope to prosper. Not only do they need to take a more holistic approach to analyzing and investing in sovereign debt, they also need to reconsider their strategic thinking regarding benchmarks and their tactical approach to seeking returns.
Taking a more holistic approach includes a comprehensive, unified assessment of risk in the entire portfolio – one that is more focused on each country’s underlying credit quality than traditional definitions or assumptions. In other words, those attributes that will best position a country to be able to service its debts – strong balance sheets, low leverage and the potential for robust growth – should be sought after regardless of their EM or DM packaging.
A realigning world also demands realignment in portfolio construction. A first step is to move from a market-capitalization-weighted index to one that is forward-looking and based on a country’s contribution to global growth. PIMCO’s Global Advantage® Bond Index is designed to capitalize on the evolution of global growth and credit dynamics, helping investors navigate the evolving continuum between developed and emerging market investments.
Lastly, we believe active management is key, providing the flexibility to both take advantage of new opportunities and position defensively for an array of new risks. PIMCO Global Advantage® Strategy utilizes this new GDP-weighted benchmark approach and capitalizes on PIMCO’s global resources to create a portfolio that is designed to reflect the evolving international opportunity set.
The rapidly changing face of globalization means that the world is both more integrated and less clearly delineated. PIMCO Global Advantage Strategy recognizes the dramatic economic and market changes taking place across global structures and seeks to stay ahead of the curve.