PUSHING THE ENVELOPE

To ‘push the envelope’ is a phrase that came into general use following the publication Tom Wolfe’s book about the space program, The Right Stuff, back in 1979. ‘Pushing the envelope’ essentially means to attempt to extend the current limits of performance, to innovate, or go beyond commonly accepted boundaries. The phrase was often used by test pilots who were continuously going out of the comfort zone in the ‘flight envelope’, which in turn is the description of the upper and lower limits of the various factors that it is safe to fly at. It is thanks to the guys who had ‘the right stuff’ that we have a space program today and therefore satellites and with it, global communications and the other technological advances that space flight brought along. In essence, it initially took a few brave men to make it all possible. At the time, most people thought they were crazy…Today, investors are also challenged to perform beyond the comfort zone. Especially those who need to produce reliable returns in the long run, such as pension funds and insurance companies. Now that developed market equities proven to be volatile and arguably directionless and fixed income is not offering enough yield to achieve the needed long term investment objectives.

We are in a low interest rate environment, partly because of the low growth but possibly also because of the enormous and unprecedented money supply by policy makers in the US and Europe. The merits or perils of quantitative easing is a huge subject with a big debate of its own, but essentially, while it seems to be the only feasible solution to avoid economic destruction in the short term it grows a problem in the long run, especially for those investors that need to cover liabilities that lie in the future. Low interest rates compound the problem because they fail to achieve the long term goal of growing asset values required to meet financial obligations in the future, this is especially true for the pension industry, where this problem is also known as ‘the funding gap’. In addition, for those who believe that all the money printing will result in high inflation, the issues at hand are even more challenging.

Traditionally, pension funds have for a great deal relied on attractive long term yields and the compounded interest rate dynamics took care of most of the challenge of covering the future liabilities. Then you had equities, usually applied in less proportion, and if held in the long run, they would provide diversification and add the additional returns to ensure return objectives could be met. Not only are long term investors faced with very low interest rates, but the fact that most developed world indexes have suffered a negative return over the last 10 years isn’t helping at all.

Back to bonds, even the category A emerging market debt space is offering similar interest rates than those offered by the developed countries. In reality, there should be no reason for them to pay higher interst as most of these economies simply have a much better credit score. With regards to equities, the major emerging markets have caught up with developed market valuation levels, much reducing the premium for being exotic, now that the world sees a bright future for these economies.

The good news is that emerging markets are still expected to perform on the back of their economic growth, but the long term investors still need higher returns to make up for all this time they have had their head stuck in the sand. These investors cannot continue to procrastinate, they need to do something and find reliable ways to increase returns, they need to move out of the comfort zone and push the envelope.

After the experiments in hedge funds and in the alternative investment space mostly failed, the ‘Frontier Markets’ are the probably the way to go. They are the new rising economies. They offer a premium because they are exotic and not fully understood by global investors. A large proportion of the globe’s population lives there and they are growing very rapidly.

Today, many publications write about these new economies and I find that everyone seems to agree that these are the places to reckon with going forward. Many investors still worry about the political stability there, but in all earnest, can the developed world really claim political superiority after all the trouble irs political leaders have gotten it into during the past two decades? Can we really?

Long term investors like fixed income, so let’s have a look at this asset class in this brave new world:

First of all, the frontier fixed income universe is now growing very fast. We are seeing unprecedented bond issuance on the back of swelling demand. Much of this demand is fof local origin and we are seeing the first institutional investors now increasing their allocation to the higher yields in this asset class.

Despite the high growth in the local currency bond universe, it exists in parallel with hard currency issuance. Much of pricing mechanism is still outside of the local markets so these issues are systematically traded at a handsome premium. This is illustrated on the chart below. This is interesting for international investors, who can get much of these high returns without having to even foray into the local currencies. However, we think they should also seek exposure to local currencies because they are still not reflecting the full future potential of these economies and are therefore undervalued.

The local currency is a space to watch. As these economies grow, there are more and more local institutional investors in the system who also need to match future liabilities so strong demand for local currency bonds is here to stay for a while.