Sector Focus: Emerging Markets and Corporate Bonds

Sector Focus: Emerging Markets and Corporate Bonds

At present IFAs are, on the whole, bullish about emerging markets and bearish about the UK corporate bond market.



Emerging Market sector

Invesco Perpetual [Report] points to a mixed global picture last month, with markets in India, Malaysia and Indonesia performing best. India's Sensex 30 increased by 8.8 per cent while the Jakarta Composite rose 7.5 per cent.

In contrast, the Istanbul Stock Exchange National 100 index declined 8.7 per cent, while the Brazil stock market also dipped on the back of increased political turmoil in the South American country. Turkey's stocks were depressed by the country's failure to appoint a permanent central-bank governor. Indeed, local rather than global issues tended to drive equity prices, Invesco concludes.

Although the MSCI EMF Latin America index fell 2.6 per cent, both Argentina and Mexico posted gains, with steelmakers in the former country driving growth of 5.0 per cent.

Elsewhere South Africa's benchmark FTSE/JSE Africa All-Share index hit a record high in the last week of March, fuelled by mining companies such as Anglo American amid fresh record highs in copper and zinc prices. Gold rose above US$575 an ounce for the first time in 25 years. Now the price of gold stands at $638 an ounce.

New Star [Report] reports that the overall emerging market index (MSCI Emerging Markets Total Return Index) "paused for breath" over the last couple of months with a narrow loss of 0.1 per cent. However, it pointed to high growth in the energy-heavy Russian equity market and modest growth in the MSCI India Total Return Index (2.5 per cent) and the MSCI China Total Return Index (3.2 per cent).

Schroders [Report] attributes the stall in emerging markets to concerns that US rate rises will sap demand for the region's assets. It also noted record growth in Indonesia, as well as in Venezuela. On a sector basis, materials, industrial and energy gained while IT and utilities slipped.

AXA Framlington [Report] says that increased volatility in markets such as Turkey and the Middle East suggests the risk premium has got too low.



Emerging markets: what does the future hold?

Growth prospects in markets such as South Africa, Vietnam and Kazakhstan look attractively priced for the future, according to AXA Framlington [Report].

Indeed, separate reports last week reveal that international banks are scrambling for a toehold in Kazakhstan's financial assets. The country's oil and metal exports are hitting record highs – including record copper, zinc and gold prices – and consequently Kazakhstan is being flooded with dollars.

However, financial assets are scarce in the central Asian country, as most Kazakh firms are not listed and local currency debt markets are tiny. The only avenue for investors is the corporate bond sector.

"Investors are keen on the Kazakhstan story and can't wait to get in but the fact remains that local bond and stock markets are very limited. For now, corporate bonds provide the only real angle," Merrill Lynch economist Mehmet Simsek told Reuters.

Elsewhere, some investors have argued that the momentum of the Asian markets will run out of steam as increased investment causes overpricing. However, industry experts said this month that stocks in emerging markets such as China and South Korea are still reasonably priced.

Mark Mobius, manager of the Franklin Templeton fund, said a major sell-off in the region would probably not take place in the next few years because developing markets remained inexpensive.

He said the best value was in Korea, followed by China/ Hong Kong and then Taiwan Asia has received approximately $17 billion in foreign investment so far this year, more than ten times the amount of the same period in 2005.

Others point to Russia as one of the leading emerging markets on the planet. Russian economic growth has been underestimated and it is fast catching up with the developed world due to its abundance of natural resources and strong workforce.

"Gross domestic product growth in dollar terms - around $3,000 (1,680 pounds) per head - may well triple over the coming five years due to real growth, high wage inflation and a stable exchange rate," Jochen Wermuth, managing partner of Germany-based Wermuth Asset Management, told Reuters.

"Average monthly wages of currently only $327 could reach $1,000 a month ... earnings of companies focused on the domestic consumers should triple too."

AXA Framlington [Report] recommends making investments for the long term (at least five years) as past performance is not a guide to future performance. Highest returns will result from investments in new markets, smaller companies or single sectors, although they also involved a higher degree of risk.




UK Corporate bond sector

Moving on to the UK corporate bond sector, Scottish Widows Investment Partnership (SWIP) [Report] says corporate bond markets are at historically tight levels but spreads in investment grade credit are stable.

It attributed the fall in gilts over the first quarter to strong economic data and steady inflation which dampened hopes of an interest rate cut.

However, it predicts a cut in interest rates from 4.5 per cent to four per cent over the next year, offering the potential for an accompanying rally in UK bonds.

SWIP also forecasts UK gilts to outperform European government bonds over the next 12 months.


M&G Investments [Report] said corporate bond returns were broadly in line with government bond returns. It said exposure to the telecoms industry has been reduced, voicing concerns that its under-performance in the equity market will filter through into the bond market. Regarding the retail market, it has reduced its exposure to Tesco because the company has opted to enter the highly competitive US market, thereby increasing its credit risk. Meanwhile, Goldman Sachs looks attractive on a risk/reward basis because it has been bought and is expected to increase its operating performance.

Schroders [Report] recommends issuing bonds against the UK water utility sector, which favours a climate of slow economic growth, in addition to the energy sector, whose value is going up.



The outlook for the UK corporate market

Analysts are generally cautious of the outlook for corporate bonds, although most predict a slight drop in interest rates over the next year. SWIP [Report] forecasts UK gilts to outperform European government bonds over the next two years, but is reluctant to back corporate bonds due to their limited yields spread of gilts.

However, the Schroders Corporate Bond Fund [Report] is positive on the outlook for corporate bonds, forecasting investors to continue searching for higher levels of yield. It stressed that credit conditions may deteriorate as default rates start to gradually start rising, "but this should play to our stock selection approach to investing".

But slim hopes of an immediate interest rate cut were further diminished this week after unexpectedly strong UK retail sales and mortgage lending figures. As such, gilts were lower and underperforming their European counterparts.