From cyclical booms to structural strength

At AXA Investment Managers, we believe the EMD market is more attractive now than in 1997, but potential pitfalls still exist that should be considered. We also believe that analysing EMD sovereign debt is extremely important and a long/short EMD investment approach should be most beneficial in the current environment.

more attractive than in 1997

A number of factors support our view that EMD is a more attractive investment now than in 1997. One key reason stems from a major shift in exchange rate regimes that has occurred from 1997 to 2004. Most countries have moved from a crawling peg to a floating regime, giving them the ability to finely tune their economies through the value of their currencies. Furthermore, most countries had negative balance of payments in 1997, whereas now they are very positive in Asian and Eastern European countries and above neutral in Latin American countries. Therefore, foreign exchange reserves in all three regions cover a larger share of their short-term debts.

The US interest rate environment is also encouraging. The high level of liquidity that the central banks are injecting into the global economy is unprecedented. The US Fed Fund rate is currently at 1%, compared to 5.5% in 1997. So, not surprisingly, the search for yield has been a major support for EMD. Moreover, we anticipate that central banks will remain accommodating for longer than usual and, thus, continue to support the more risky, higher-yielding assets.

Local markets have increased in size and depth over recent years and experienced domestic investors are now investing in sophisticated products. In addition, the creation of local pension funds and increased demand have resulted in a stable investor base, which in turn allows EMD countries to issue longer-duration debt. External investors now coming into the EMD asset class are more oriented towards long-term investment. Investment from US crossover funds has increased, as higher credit ratings now enable them to diversify into the EMD market.

Deeper markets have also diminished the dominance of hedge fund players and the resulting de-leveraging in the market has reduced the contagion concern (that is, if one emerging country's economy collapses, the other markets follow). The best example of this was provided in 2001, when the emerging market index had positive returns despite the complete collapse of Argentina, which had been the index's biggest weighting.

Another major reason for our optimism is the improving quality of management in EMD countries. Market-friendly economic policies are now widely recognised as necessary to attract foreign investment.

For Eastern European countries, the previously depressed economies of potential members of European Montary Union are quickly becoming more developed. Latin American countries are striving not to follow the Argentinean example. Meanwhile, Asian countries are benefitting from a combination of stronger domestic demand and exports, which should create firmer growth.

As mentioned earlier, credit quality has improved greatly. In 1997, only 7% of the Emerging Market Bond Index Global Diversified (EMBI GD) was investment grade - now over half the index is. This credit quality improvement is a clear indication that ratings agencies are upgrading their estimates of EMD country authorities to manage their economic policies better.

Finally, the entry of some of the Eastern European countries into the EMU seems to be inevitable and irreversible. In the last five years, we have seen Poland, Hungary and the Czech Republic converging with Europe and the spread of their external debt is very tight, offering almost no value.

potential pitfalls still exist

Our optimism does not come without a certain amount of caution, however, including concerns over the current spread levels. The Fed Fund rate is a key driver of flows into and out of EMD, and the current low level of EMD yield spreads may not protect investors from a rise in US interest rates. Up to now, the level of carry has provided some protection from underlying movements in interest rates.

A fall in global liquidity will hurt the riskier countries, which benefit more from the 'search-for-yield' attitude than from a pure improvement in their macro picture. In addition, the countries that have high financing needs will suffer directly from global monetary tightening. For example, Turkey and Brazil are likely to suffer because of their short-term-debt needs.

Also of concern is the outlook for commodity prices. Even if China's commodity needs remain high and support all the commodity markets, countries that are net exporters of commodities may still face pressure if the pace of growth falls progressively in 2004.

Furthermore, an increase in terrorist attacks may reduce the flows to riskier, weaker countries and create a feeling of global insecurity that could lead to a deceleration of growth in the main economies.

Important considerations

We believe the best approach to investing in EMD is to score different countries through four main factors: economic fundamentals, political situation, indebtedness ratios and positioning of the market participants.

Economic fundamentals. The macroeconomic environment is extremely important, as the investor needs to be certain that a sovereign issuer is able to repay its debts. Countries that are export-oriented and rich in commodities are especially attractive. Also, one should consider the pace of internal growth, the level of foreign exchange reserves and the fiscal and external accounts.

Debt and market rates. Consider short-term interest rates, the exchange rate, debt burden and potential new issues. These factors should help paint a picture of a country's ability to service its debt. In a market downturn, a country that has a large portion of its debt due within one year will find it much more difficult to refinance its debt. Turkey provides a good example of this, with its large exposure to short-term interest rates making it sensitive to changes in liquidity and market rates.

Market sentiments. In particular, we look at a country's rating outlook, technical position and inflows. For the latter, we usually look both at brokers' and consensus views to estimate the positioning by major players in the respective country.

Political climate. The country's political situation should also be considered very carefully. Radical political structural changes should be analysed and the expected premium should be evaluated to see whether it compensates for the extra risk. Countries with good political leaders and stable political systems are especially attractive. For example, the election of president Putin in Russia has re-established the power of state and has provided the necessary stability to stop the bleeding of capital.

Taking into account all the parameters mentioned above, we believe an active long/short investment style, such as the one we use for our NEO Fund, would be the best approach in this environment for a number of reasons. For one, the style gives more flexibility in duration management, especially considering that the EMBI GD has a long-duration profile - currently six years, giving an average maturity of seven years.

Also, in terms of diversification, the ability to invest in different assets (especially the ability to invest in both local and external debt) allows managers to create portfolios with low correlation, whereas the major indices are concentrated in only one asset class (either local or external debt).

In addition, local debt markets in investment-grade countries have matured and successfully de-coupled from external debt. They follow their own dynamic path with higher liquidity and reduced volatility, as high participation from local and crossover investors have increased the depth and attractiveness of the local debt markets.

Finally, this type of approach allows managers to go short weaker credits or countries, either through the Repo market or by using a credit default swap.

We believe the outlook for EMD is positive for 2004, although we do expect the main index returns to be more modest than in previous years. Making a call on the US economy will be required, as will being selective in choosing credits that will be least vulnerable to the US outlook. Therefore, an active long/short investment style should be the best approach in this market.

Nadine Tremollieres is head of the emerging market team at AXA Investment Managers, which she joined in April 1998. Previously, she had spent 12 years with CDC Marchés in Paris and in New York, where she held various positions on the trading floor including French OAT market maker, foreign exchange trader for Asian currencies and swap trader on G7 markets.Ttremollieres holds a management degree in economics and finance from Ecole Supérieure de Gestion, Paris.

Key Points

Most emerging markets have switched from a crawling peg exchange rate regime to a floating rate, giving them greater economic control.

EMD countries have realised that market-friendly economic policies are now widely recognised as necessary to attract foreign investment.

The best approach to investing in EMD is to score countries by economic fundamentals; political situation; indebtedness ratios and positioning of the market participants.

An active long/short EMD approach is currently preferable as it allows managers more flexibility in managing the duration of debts.