Is Emerging Market Debt Attractive Again?

Selectively, yes – after last year’s sharp FX adjustments, the macro risks such as deficit funding cover, excessive consumer credit growth and deteriorating terms of trade which were overlooked by the bullish consensus a year ago now look adequately discounted for many countries. The World Bank, in a report released this week warned that: ‘In a disorderly (QE) adjustment scenario…nearly a quarter of developing countries could experience sudden stops in their access to global capital. For some countries, the effects of a rapid adjustment in global interest rates and a pullback in capital flows could trigger a balance of payments or domestic financial crisis.’  As the ‘Great Unwind’ from the extraordinary monetary policies of recent years begins in the US (and possibly the UK but not anytime soon in Europe while Japan will open the floodgates wider), blood curdling warnings like this are commonplace. Aside from the ever prescient BIS, such caution was very rare a year ago as indiscriminate retail inflows drove spreads versus Treasuries to historically low levels, particularly in ASEAN markets and IB strategists led the cheer leading. Emerging market fixed income ended up posting its third negative annual performance since 1998, driven by rising US Treasury yields from May as tapering entered the investor lexicon and caused a sudden reversal in ‘hot money’ portfolio inflows.

After a deep correction through H2, EM hard currency corporate bonds outperformed sovereign debt, returning a negative 0.6% versus -5.3% for the full year, boosted by shorter duration and correlation with stronger performance in global investment grade and high yield credit. EM corporate bond spreads, (as measured by the JPM Corporate EMBI index), are now flat to USD sovereign debt which translates into a narrowing of almost 70bps since the beginning of 2013.Therefore, asset allocation from EM sovereigns in both hard and local currency toward EM corporates was one of the key calls in 2013, as was avoiding industrial commodity exposure at both sovereign and corporate levels. Local currency debt delivered a negative total return of -9% mostly attributable to the FX component, while the carry, i.e. the additional return due to higher local interest rates, compensated for the back-up in yields. Despite the volatility from mid-year, GEM bond sales hit a record high, reaching $506bn from 2012’s previous record of $488bn, with EM corporate issuers accounting for $345bn.

Back in the May 17th 2012 note looking at EM debt, I noted that: ‘A structural re-rating of EM sovereign debt has driven borrowing costs to record lows for many countries (and who would have bet back in 2008 on Philippines 20-year local currency paper yielding well under Spanish?), enhancing their fiscal flexibility to withstand further macro volatility. Going forward, there is limited upside from further spread compression and we are likely to see greater dispersion in EM debt performance driven by diverging macro fundamentals. Indeed, stress testing a GEM equity or credit portfolio for sustained industrial commodity deflation remains a worthwhile exercise, as China’s diminishing role as ‘buyer of last resort’ impacts relative terms of trade and thus credit risk for resource exporters.’ That’s pretty much how things played out last year, with the terms of trade losers like Indonesia hardest hit by a re-pricing of credit and FX risk as current accounts reflected sliding commodity prices and unsustainable consumer spending booms.

Having seen growth squeezed by tighter policy and consumer import trends softening in recent months after sharp currency falls, an eventual narrowing of current account deficits in countries such as Brazil, India and Indonesia should see the FX selloff abate if not reverse, helping portfolio inflows to gradually resume. Local currency EM yields rose by 135 bps in 2013 to 6.85%, driven by currency weakness (South Africa), monetary policy tightening (Brazil, Indonesia), fiscal deterioration and inflation risk (Brazil), political and external account concerns (Turkey, Thailand from Q4), as well as a higher floor from US yields. This year, EM debt will be less about global macro risk and more country specific. No fewer than 12 major emerging market countries have presidential and/or parliamentary elections this year, including Brazil, India, Indonesia, South Africa, Turkey and Thailand. Aside from politics, the FX outlook is key; on a real effective exchange rate basis (trade weighted and adjusted for relative inflation rates) several EM currencies look good value and now that the Fed has provided clarity on its exit strategy  there is scope for the capital flow environment to turn more positive for EM assets, particularly if Treasury yields can be contained sub 3%  and Japanese retail interest in the EM carry trade resumes. Inflows into local equities and corporate bonds should be boosted by improving relative data momentum between GEM and particularly Asia and DM. The oversold Indonesia Rupiah would likely be the biggest beneficiary, with the Philippines peso also likely to bottom; prospects for the Thai baht hinge on the political crisis fizzling out although even a delayed election with an end to disruption would see a short covering rally.

I had a 60 productivity adjusted target versus the USD on the Indian rupee back in September amid the panic that drove it almost to 70, but it looks range bound near-term ahead of elections and with recent output and inflation data uninspiring. Turkey remains the most worrying situation which could spread contagion across other emerging markets if the political crisis escalates, given its dependence on foreign portfolio flows to cover near-term deficit funding. As noted recently, the sharp decline in industrial commodity prices since 2011 looks set to level out for several metals this year as supply deficits loom in 2015/16 so the countries most exposed offer the greatest prospects for a ‘relief’ rally.  Valuations for local currency debt look selectively attractive (in Indonesia, for instance) on the basis of the currency adjustment seen in 2013 and yields now adequately discounting macro risks.  Overall, if 2013 was the year when EM debt investors adjusted credit risk perceptions for current account funding risks and weak industrial and precious metal prices, energy may prove the key current account terms of trade risk this year for countries like Malaysia, if abating Iranian geopolitical tensions and the surge in US supply see global oil prices fall toward $90/barrel.