Em Volatility Highlights Need for Different Thinking

Boston - In recent blog posts, we've discussed why the recent ruckus in emerging market (EM) bonds and currencies was something we were looking for in what we're calling our "new playbook."

To refresh, the new playbook refers to strategies that we believe can prosper in the environment we expect of higher inflation and interest rates, dollar weakness and increased volatility. Another key concept is navigating the transition from monetary stimulus (central banks) to fiscal stimulus (governments), and its potential impact on markets.

For us, the new playbook means embracing maximum flexibility to take advantage of the opportunities presented by the large-scale transitions taking place in the economy. In this post, we'll try and make the case that the recent volatility may be an opportunity for long-term EM investors.

Going beyond EM bond benchmarks

Despite recent volatility and "contagion" talk, we still think EM deserves a place in diversified bond portfolios -- but with an important caveat.

Essentially, we believe investors who rely on benchmarks for exposure to EM debt may end up disappointed in coming years. Also, we think viewing EM bonds simply as an asset class or sector that can add value to traditional, developed-market indices may be a mistake.

Instead, we favor a flexible approach that focuses on trying to identify the individual EM countries offering the best value -- for example, countries facing near-term challenges that may be distracting investors from their long-term potential. In other words, relying solely on traditional benchmarks may be too restrictive to implement our new playbook.

Remember, in many broad bond indices, an individual country's weight is determined by its total debt outstanding. Therefore, the most indebted countries have the biggest index allocations. Instead, we think it makes more sense to focus on countries with potential for improvement and reform, and also those that may be offering compelling value after falling out of favor with investors.