Is now the time for long-term emerging debt value?

In the emerging world, healthy demographics, high returns on physical and human capital investment, and the ability to leapfrog technology generations have powered the forces of economic convergence, lifting and steadying growth.

Low interest rates rippling out from the West have further amplified these convergence dynamics. The result has been a remarkable increase in the living standards of hundreds of millions and the rise of new purchasing power in previously untapped parts of the world.

The leapfrogging and catching-up of poorer economies, however, is never a wholly smooth affair.

Complex political imperatives alongside still immature governance rules and the pull and push of global capital flows typically impart tremendous volatility.

Over the past decade, this volatility has caused financial markets to gyrate between tremendous highs and lows. But one should not be blindsided by this, as the volatility masks a strong underlying trend of both fast rising poor countries and convergence of demand. Tapping this rising demand should be a key building block for any long-term investment strategy.

After the financial crisis in 2008, emerging market resilience sowed the seeds of a renewed upswing. Hungry for yield, return and growth, global capital flooded into these economies, and as the West deleveraged and retrenched, emerging markets began to scale new heights. Over time, governments were lulled into a false sense of security. Fiscal purse strings were relaxed and domestic credit gushed freely. Demand soared and wages marched steadily upwards.

Eventually, imbalances – in the form of rising inflation, rising current account deficits, and rising external debt – began to crisscross these hitherto paragons.

Things remained stable as long as the West was pre-occupied with healing the scar tissues of the financial crisis. Over the last year, however, as evidence of a recovery in the developed world has steadily built, there has been a dawning realisation that it is simply a matter of time before the global risk free rate starts to adjust higher.

Global investors have poured out of emerging markets almost as quickly as they once poured in. Currencies have fallen sharply while bond and equity markets have stumbled. Virtually overnight, the exemplars of virtue have been turned into pariahs, and a cyclical downswing is well and truly underway.

Governments across emerging markets have also been jolted out of their apathy. Policymakers are working to reduce imbalances, reform budgets and restructure and privatise assets. Much ignored governance rules are being tightened, and graft and corruption are being reined in.

Will this reform fever fade as global pressure eases? Not this time. A new calculus has entered the emerging market equation in the form of aspirational voters. Rising living standards have created an emergent class of new voters, who are holding their governments to account. If anything, the reform agenda is only set to gain momentum as politicians dance to the tune of these new voters.

In countries like China and Mexico, where political transition took place in 2012, new leaders have had time to draw up detailed plans. Next up to the plate will be India and Indonesia, where elections are being held over the next few months for a combined population of almost 1.5bn people. In both countries, voter demand for change is thrusting reform-oriented candidates into the limelight.

Inevitably, though, there are always laggards. In Brazil and Turkey, the political response to the demand for change has been significantly less forthcoming. In both countries, elections are scheduled to take place later this year. However, as yet, the leading candidates have failed to announce any reform plans, and the risk of political unrest remains high. Still, Brazilian and Turkish interest rates have squeezed higher in an effort to attract global capital and stabilise the currencies, and this has diminished the risk of full scale balance of payments crises.

What does all this mean for global investors? Convergence will continue to pull these countries towards Western living standards, just as economic gravity continues to shift away from the West. And while the emerging market downswing gets into full gear, the reform fever sweeping across these countries only increases the speed at which convergence might take place.

Now, while fickle global capital remains disoriented by crises past, this could be the best time to hunt for long-term investment ideas.

Subitha Subramaniam is chief economist at Sarasin & Partners