Tell me what you see in the global economy.
We see decoupling between developed and developing economies. Clearly growth in the US is quite slow and growth in Europe is slowing, while growth in Asia has not slowed materially.
What all three regions are grappling with is high inflation, which is detrimental to bond holders. The Federal Reserve has brought rates down to 2%, and we think that is probably as low as they are going to go, although we donÆt expect them to be raising rates any time soon.
We believe the Bank of England, and possibly the European Central Bank, will be lowering rates. However, that is less certain because there is divergent growth within the eurozone û Germany is experiencing strong growth rates, but peripheral countries arenÆt as dynamic.
In Asia, strong growth and higher inflation portends for higher interest rates or stronger currencies. But interest rates may not temper inflation, especially when inflation is imported, as rises in food and energy prices are. So perhaps the best way for governments to address that concern will be for the regions to strengthen their currencies.
What then is your strategy for Asia?
We are therefore positive on the currencies in Asia, but the local bond markets continue to be fairly illiquid, and not as well developed as those in the developed markets, or other emerging markets around the world. We find Asian bonds to be rich since there is a lot of captive money and a lack of supply to meet that demand, which bids up the price on Asian bonds versus other emerging market bonds around the world.
We like the Asian economic growth story, the development of domestic demand and the more sound fiscal policies being practiced. We want to participate in Asian bond issuance but when managing a global emerging markets portfolio, we often find better value elsewhere in the world.
Is there less captive money in other emerging markets?
Other regions donÆt have such a strong, captive demand base. In Asia, we have large national pension plans and some very large insurance companies that are all buy-and-hold investors. Moreover, the regulatory regimes in other emerging markets are less restrictive to foreign investors. ItÆs impossible for foreign investors to invest in the Indian bond market, and very difficult for them to invest in the Chinese bond market, whereas Brazil and Mexico, for example, are much more open. So there is a demand base in Asia that canÆt gain access to these markets, which causes an imbalance in the supply and demand equation.
What about dollar-denominated debt?
We are seeing a decline in the overall issuance of hard currency, emerging market debt as local currency markets develop. Since local currencies are appreciating against the US dollar, there is less incentive to borrow in dollars and swap back into local currencies û borrowing in a weak currency and swapping back into a stronger currency doesnÆt make sense, unless you have hard currency spending liabilities.
Meanwhile, there is also a captive demand for these bonds: many of the local entities that are allowed to invest offshore buy hard currency corporate and sovereign debt from their own countries, because they know and are comfortable with those issuers.
So we prefer local currency debt in shorter maturities over hard currency debt, and are focusing on the higher quality credits in countries that are commodity exporters, such as Brazil, Russia and Mexico.
WeÆve seen a big rally since the Bear Stearns episode. WhatÆs your outlook?
In an environment of inflation and potentially slow growth, we are generally cautious of credit risk across our portfolios, although we prefer it relative to interest rate risk. This is a move we have adopted over several months as interest rates declined substantially and treasuries became the richest assets in the world, on par with some commodities assets. Therefore, we believe that credit duration is better risk for our clients than interest rate duration. As a result, we have been moving into high-grade credits, and continue to hold emerging market credit, which has clearly repriced. We are finding some value in that area.
Have you been seeing much redemptions?
Lately, weÆve seen money come into fixed income because of concerns about the slowdown. Now weÆve had quite a rally in equity markets over the past month, and there have been more concerns about inflation, which is certainly bond negative. We wouldnÆt be surprised to see the flows temper a little, unless the slow-down in the US becomes reflected in lower expected earnings and stock prices. At the moment though, the market continues to price in strong profit growth for 2008.
This story was first published in the June issue of FinanceAsia magazine.