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. 

Political Populism Means Thailand Continues to Underachieve…

9th October 2013

Thailand is probably the most disappointing emerging economy in Asia and possibly across GEM, in terms of economic and political progress over the past decade. While unemployment is practically non-existent, productivity has stagnated. Graduates from local universities are generally only fit for (and satisfied with) low skill call centre/retail work, while factories face a labour shortage as farm workers enjoying the subsidy bonanza stay in the rice paddies. Infrastructure investment has been a paltry 1.5% of GDP and trend GDP growth has stalled at around 4% over the past decade, while private sector credit to GDP has risen to 150%, after a consumer lending boom. Overall, the country’s competitiveness has been slipping versus regional peers; in the World Economic Forum’s latest competitiveness rankings, Thailand ranks 74st globally in health and primary education provision and 85th in the quality of its institutions, 50 places lower than Malaysia and significantly weaker even than Indonesia. The seven year build out of infrastructure to integrate the wider sub-region around Thailand as a logistics and finance hub will be critical to boosting the medium-term growth trend toward 5%.

The long-term challenges facing Thailand include a fast ageing population, out-dated infrastructure/ industrial plant and a weak education system at all levels. To boost trend growth to mid-single digits, Thailand will have to bring significantly more workers into the formal economy, boost productivity enhancing investment and reduce glaring income inequalities that have undermined political cohesion. For investors, a sustained period of political stability is important in tackling these structural issues, although the current subsidy program to boost rural incomes, while reducing extreme income inequality, is having unintended consequences.

Indeed, the central bank governor warned recently that the populist subsidies “add to micro-level risks by making households addicted to ‘easy’ money, while also adding to macro-level risks by stretching fiscal resources without enhancing competitiveness in any meaningful way.” Corn famers for instance have been protesting to force the government to extend the current subsidy program due to end in December for another four months. The country has seen a range of other special interest groups from rubber to corn farmers demand hand-outs of their own. The subsidies are adding to rising public spending, led by the 700bn baht, or $22bn to support rice farmers since the 2011 election. Thailand’s rice subsidies, which bought up rice from farmers at double the market price, also have knocked the country from its position as the world’s largest exporter of the grain as huge domestic inventories build, as cheaper rice from India and Vietnam took market share.

Thailand’s finance ministry recently cut its growth forecast for this year to 3.7% from 4.5%, which still looks a bit high – growth should rebound to 4.5% next year if the delayed infrastructure program begins to be implemented. Exports account for around 60% of GDP but Thailand is trapped in low end assembly operations, without the education system or infrastructure to move up the value chain. At the same time, the government’s goal of raising living standards and consumer spending in rural areas appears to be having unintended consequences. Some farmers are using the promise of guaranteed future incomes as a basis for borrowing more money. High prices guaranteed by the government are encouraging over-investment in farming.

Tax revenues are only 18% of GDP, and a proposed corporate tax cut to compensate for higher mandated wage costs will be hard to offset elsewhere. By law, public debt must not exceed 60% of gross domestic product, from 44% currently, but is forecast by the IMF to rise to 52% by 2018. On a net debt basis and excluding the liabilities of majority government-owned state-enterprises current debt is around 21% of GDP. While those debt levels look modest, private debt is the key concern, and the public debt picture is clouded by Thailand’s population ageing faster than any other in Southeast Asia apart from Singapore, with the proportion of the population over 60 in Thailand will reach 20% by 2025 with minimal pension provision, as mortality and fertility decrease steadily. Only South Korea and China face a similar demographic challenge in the wider Asian region while net foreign investment has been trending downwards, helping to exacerbate an overall shortfall in investment, which has run at under 30% of GDP in recent years.

The 2011 election campaign focused on tackling income inequality, which has become a key regional theme. Income inequality in Thailand is more extreme than in other regional emerging economies such as Indonesia, Malaysia and the Philippines, with the wealthiest 20% of Thais earning over 14 times more than the poorest 20%, compared to 9-11 times elsewhere in the region and 5-8 times in Europe and the US. The Puea Thai party offered to guarantee a uniform daily minimum wage of 300 baht ($10) throughout the country, rising to 1,000 baht by 2020, universal medical care for under a dollar a visit, a $500 monthly starting salary for graduates and a debt moratorium focused on low earning civil servants and farmers although the most expensive promise was the rice subsidy.

Despite the robust real growth in manufacturing since 2000 (an average of over 6% annually) the share of the workforce employed in factories has stayed at about 14%, with another 3% employed in export related logistics. Increased automation and worker productivity supported higher output, but did not contribute to integrating more Thai workers into the higher value-added export sectors.   The weak employment performance of manufacturing has fed the core political problem of growing wealth concentration (one which China also now faces). The country’s income inequality is the result of many divisions including the oft cited urban-rural divide, but also one between Bangkok and the rest of the country. Less than 20% of the Thai population lives in Bangkok and along the Eastern coastal region but generate over 70% of the country’s GDP and consume the bulk of public resources such as education and healthcare. This deep rooted inequality will continue to be a source of recurrent political instability in the months and years ahead, particularly if economic growth continues to lose momentum…

India in Eye of GEM Currency Storm…

27th August 2013

Does history repeat itself, as if we learn nothing from one crisis to another?”

Duvvuri Subbarao, outgoing head of the Reserve Bank of India, speaking recently

Or rather another 1991 in India’s case. It’s remarkable how complacent GEM bond and equity investors have been regarding deteriorating external balances, a key factor which I’ve highlighted repeatedly over the past year as a driver of portfolio allocations. Korea or China might have had relentlessly negative earnings momentum, but no risk of a destabilizing margin call from global markets. We saw endless sound bites in recent years about how much stronger GEM solvency and fiscal dynamics were versus developed world, justifying the dramatic re-rating of EM debt. In fact, stripping out China and the Gulf oil exporters, the aggregate current account balance of emerging economies has slumped from a 2.3% of GDP surplus in 2006 to about a 0.75% deficit this year, the biggest since 1998. In recent months, that stark reality has begun to be reflected in divergent risk premia.

India has been a focus of that re-pricing; FX reserves now cover its CA deficit and short term debt (by residual maturity) by just over 100%, down from 400% in 2005. Coverage of total external debt plus the CA is down to just 60%. Only South Africa and Turkey are in such a weak funding position within major GEM economies; in contrast, Brazil’s reserves are double its gross financing needs.  Indonesia is in an ever weaker coverage position and saw the most savage selloff last week, with the IDR down 6% against the USD and the JSE down almost 9%. Policymakers in both India and Indonesia are flailing around with new policy initiatives to stem the panic. However, curbing the voracious local appetite for BMW imports in Jakarta with import tax hikes isn’t going to help much, and rates have to move positive to stem the rout, implying further hikes of at least 100-150bps and GDP growth slowing to sub 5% next year. As highlighted in several notes since last December, the country was a prime candidate for a panic like this.

About $22bn in private sector debt repayments are scheduled for H2 in Indonesia; the $119bn increase in total external debt position from 2006 to 2012 included private sector external debt rising by $48bn. The debt/export ratio stands at a current 120%, reflecting weak commodity export prices. Short-term Indonesian external debt by residual maturity stood at almost 59% of FX reserves as of end July. In other words, the panic is far from irrational as GEM portfolio inflows have reversed sharply since mid-May, and the question now is whether it feeds on itself or gradually calms. There are plenty of reasons to be relatively sanguine, not least the unseemly scramble by previously bullish but as ever momentum chasing IB analysts to slash FX and equity market targets.

Private sector debt as a ratio of exports was about 50% higher in Korea in 1997 than it is in India now; while India’s fiscal deficit is much bigger than those across Asia in the 1990s crisis, high nominal GDP growth means that India’s debt/GDP ratio has been declining even as deficits have remained high to about 66% now on IMF estimates. However, the debt situation is more ominous for the private sector should rates spike/funding dry up; many Indian companies have been on a borrowing binge. Since 2007, borrowing by the country’s 10 most indebted companies has risen from $20bn to about $120bn, with much of that denominated in foreign currencies as the offshore corporate bond market has boomed. Total short-term external debt has risen from $80bn to $170bn. Private firms that owe the bulk of India’s foreign debt will be under intense solvency pressure if the rupee stays below 60 for long. This makes the balance sheets of India’s state-owned banks ever more shot to pieces; they already have bad loans equivalent to 10-12% of their loan books, but in reality above 20% adjusting for ‘restructured loans’.  That second round impact of a weak rupee is one factor complicating the RBI’s task in focusing on growth.

The rupee’s fair value, taking into account India’s relative inflation and productivity is just under 60 versus the USD and after overshooting toward 70, we should eventually see the market stabilize at around that level by early 2014. Total FDI and portfolio investments amount to over 25% of GDP and sustaining foreign investor confidence will be key in coming months. The current account should start improving to sub 4% this FY on a belated export response and weaker gold imports (and gold prices in rupee terms are also at a record). The longer-term solution to the CA deficit has to be India’s domestic manufacturing sector, and industrial exports.

Does History Risk Repeating for Indonesia?

I’ve been cautious on Indonesia since late 2012, terming the country a ‘macro accident waiting to happen’ and moving underweight local equities in late Q1, but a late 1990s style capital flight crisis looks very unlikely unless local policymakers again display remarkable incompetence. So far, despite several missteps, they have retained credibility. Back in the 11th December weekly looking at Indonesia’s generous minimum wage hikes, I noted that: In 2013, there is a growing risk that either inflation lets rip or the trade deficit turns ugly. In either case, BI would be forced to hike rates to defend the IDR. Brazil offers a cautionary tale of excessive domestic consumption growth gone horribly wrong, in the absence of structural reform and infrastructure investment, with a crashing currency as the solution.’ 

And that just about sums up the past few months; the country’s GDP growth fell to 5.8% in Q2, and with a surge in inflation to 8.6% last month, sustained IDR weakness and overall a broad stagflation trend, echoing the pattern from India to Brazil in recent years. This is partly the result of the ‘terms of trade shock’ for commodity exporters, a key macro investment theme which is the flipside of China’s new lower trend growth rate.

Rising consumer spending has been a key pillar of Indonesia’s growth acceleration in recent years, alongside burgeoning natural resource exports, but the latter has been badly affected by the slowdown in China. The impact of this slump alongside the recent 75bps BI rate hikes is beginning to damage broader confidence in the economy and will dampen growth in domestic private consumption, the crux of the bull case. The IMF has recently estimated that each percentage point fall in Chinese trend GDP growth could cut as much as half a percentage points from Indonesian growth, via the commodity export impact.

International financing costs for local corporates are rising as markets anticipate a tightening of US monetary policy reflected in 10-year sovereign yields breaking 8%, a level at which as highlighted in recent notes inflation risks are fully priced in and which has attracted opportunistic foreign buying. Import costs, notably for capital goods, have been pushed up by the rupiah’s depreciation of nearly 9% against the dollar over the past year while business leaders also fear growing political interference in the economy ahead of the presidential election next year. Both factors are capping investment growth, critical to avoid an Indian stagflation style outcome.

Private consumption is still strong, boosted by those minimum wage hikes, expanding 5.1% y/y in Q2. However, investment growth slowed to 4.7% y/y from 5.8% in Q1, accounting for most of the overall slowdown and has now fallen for four consecutive quarters in an echo of India’s structural growth slowdown/supply side inflation crisis. Base-year effects skewed investment, which slowed in y/y terms to 4.7%, but bounced 3.1% q/q seasonally adjusted following a flat quarter in Q1. Policy makers have indeed now given up on supporting the IDR, which has broken decisively through 10,000 versus the USD and saw its worst monthly performance since 2009 in July, adding to inflation upside risks.

Are there echoes of the 1997/8 backdrop in Indonesia’s current outlook? Yes, to the extent there are also echoes of that period across much of Emerging Asia, after a period of rapid credit/GDP, real estate and wage growth with record carry trade driven foreign capital inflows across the region and wider GEM starting to reverse. Global funds pulled $3.6 billion from Indonesian stocks and bonds in the three months through July, amid a general GEM rout on USD strength; globally, this has been a year for a ‘barbell’ strategy of developed and frontier equity markets, with the BRICs a horror story and ASEAN markets turning volatile, with the JSE struggling to rebound from the Q2 selloff.

Longer term, like say Mexico, Indonesia offers a compelling secular consumer income EM growth story, but while Mexico has begun radical structural reforms and an ambitious multiyear investment program under its new government and is attracting a surge in manufacturing FDI, any sustained equity re-rating seems unlikely until the commodity/China growth cycle bottoms out and we have clarity on whether post-election policy making will continue along the recent haphazard but on-going reformist path. A 15x current year forward JSE multiple looks full until at least some of the macro uncertainties clear.