Emerging markets sit this week between two important elections. In Turkey last weekend, President Erdoğan secured another term, and a parliamentary majority. In Mexico this coming weekend, AMLO (Andrés Manuel López Obrador) is a clear favourite to emerge as winner in the country’s presidential elections, while the control he secures over Congress is less certain. How do we view both events?
In Turkey, President Erdoğan’s dual victory on Sunday was met with only the briefest of rallies the following day in the Turkish lira, before it snapped out again versus the US dollar. While Erdoğan’s re-election offers markets continuity, structural challenges remain: a high current account deficit, a weak currency, and rising concerns on the quality of growth all testify to Turkey’s vulnerability at a time of US dollar strength. On the political front, Erdoğan’s ongoing undermining of both central bank independence and civil society should concern investors.
Despite Turkish sovereign spreads appearing optically cheap for the country’s BB rating, we retain an underweight in the country, avoiding exposure to the sovereign, and instead favouring selected corporates where we believe the bottom-up stories are strong enough to offset the headwinds at the macro level, offering value at the same time.
In Mexico, markets wait to see if AMLO will prove a President more in the mould of Brazil’s Lula, or Venezuela’s Chávez. A strong performance for AMLO’s Morena party in Congress, in addition to his winning the presidency, could steel his more radical side in the months ahead. On the other hand, as Mayor of Mexico City, AMLO played a relatively constructive role, with Mexican blue-chips such as Cemex having a positive experience working with him.
We remain cautious. While the US President is upping the ante regarding global trade, including of course with regard to negotiations around NAFTA, the temptation to fight fire with fire might prove too great to resist. While Mexico is an economy that enjoys stronger fundamentals than Turkey, a meaningful deterioration in Mexican-US relations could quickly prove damaging. We think Mexican assets are ones to avoid at this time.
For both Mexico and Turkey, elections come at a time of heightened global strain, economically and politically. Positioning away from them makes sense.
Listen to our EM specialist Theo Holland to find out where a buying opportunity has emerged
Growth outperformance versus developed markets is increasing again.
Emerging market GDP minus developed market GDP
Source: International Monetary Fund, World Economic Outlook Database, April 2018
…and a buying opportunity has emerged: EM corporate spreads are trading outside their DM peers
Developed markets high yield versus emerging markets high yield
Source Bloomberg as at 23 May 2018
The first quarter of this year has seen a significant amount of new issuance from African sovereigns. Moreover, much of this has come at longer maturities, with, for example, Egypt, Kenya, Nigeria and Senegal all issuing 30-year paper in the past few months.
Some commentators have seen this as some of sort of market top or overreach. And while undoubtedly ambitious, our view on the continent remains a constructive one. Here’s why we are investing in a wide range of attractive opportunities in Africa:
- Limited supply: in emerging markets high yield (EM HY), the sum of outstanding dollar issuance at $79bn remains well shy of other regions, such as Latin America ($368bn) and Europe ($211bn)
- Diversity: 16 African countries are represented in EM HY, more than in all the other EM regions except Latin America
- Resilient commodities: we have seen widespread strength across the commodities complex over the past year, such as in oil and copper, supporting many African economies
- Politics: generalisations should be avoided, but we see supportive political developments afoot in South Africa, Kenya and Angola currently, to name a few geographies
- Manageable indebtedness: while the pace of bond issuance has been significant in the past five years, overall debt levels are still manageable, and are significantly below levels of the last major debt restructuring
- Staying out of East-West tensions: as the US begins to challenge its traditional partners, such as Mexico and China, African credit arguably represents a ‘place to hide’
Last week saw markets once again roiled by developments at their core – the United States. The S&P 500 index is testing its February lows. But for emerging markets, where fundamentals are improving, why does this matter?
Several strands of news are competing for investors’ attention at the moment. Most of them are coming from the US: the challenge to the tech sector, which has led equity markets to their current, arguably breathless, levels; increasing noise around inflation, to the backdrop of rising interest rates; and an administration seeing high turnover in key personnel, while taking steps to challenge long-held consensus views on trade.
Emerging market investors might like to think that the many diverse geographies in which we invest can be immune from such ructions. This is incorrect – the two are interlinked.
Chart 1 shows three month dollar LIBOR expectations for the next two years versus EM sovereign high yield spreads, during 2013’s ‘taper tantrum’. As we know, the Federal Reserve didn’t actually begin to raise interest rates until December 2015, but in spring 2013, expectations around rate rises in the next two years spiked, and this change in the core had a dramatic effect on EM spreads:
Chart 1: EM sovereign HY spreads versus US rate expectations, 2013
However, we need to do more than say ‘be risk averse when core conditions are appearing to tighten’. If we take the same chart forward to late 2016, as in Chart 2, when President Trump was elected, we see a divergence between the two indices. Let’s add in the US dollar here, too, and we can see that it has been a newly growth-oriented US economic policy, driving higher nominal yields, translating into a weaker currency, helping move EM spreads better since then:
Chart 2: EM sovereign HY spreads versus Eurodollar future and US dollar, 2016 – 2018
What about going forward? We wonder if US equities could take over as an important driver of EM spreads. Here is the S&P 500 index (inverted) against the same EM spreads measure, but going much further back:
Chart 3: EM sovereign HY spreads versus S&P index (inverted), 1998 – 2018
Whether equities prove critical from here or not, the message to the EM investor is clear – not paying attention to the core could be a mistake.
At Kames our approach to emerging market debt shares some of the underpinnings of ESG investing. Moreover, this focus has always been integral to investing in emerging markets, long before its strands became as widespread as they are today in developed markets investing. In emerging markets, numbers have always been only half the story. Below are some thoughts and examples of what else counts.
The most important ESG factor in emerging market debt is governance. At both the sovereign and corporate level, bad governance in emerging markets can impair an investment well beyond the level typically possible in developed markets. Simply enough, the backstop of the rule of law, relied upon by investors in developed markets, is much less tested in emerging geographies. This means that the quality of the people (whether government ministers or management teams) and organisations (Ministries of Finance, Central Banks, and the like) involved is vital.
A good example at the sovereign level are the two West African countries Senegal and Cote d’Ivoire. Both score well on the highly-regarded Ibrahim Index of African Governance. Both are members of WAEMU, the West African Economic and Monetary Union, with its emphasis on co-operation, stability, and its ties to France. In addition, Senegal arguably has a stronger democratic tradition than many of its regional peers. Such indicators of governance strength are critical pillars of the credit cases in these names.
On the negative side, our view of Russian private banks and corporates is consistently held back by the encroachments of the state on the business interests of independent actors there. Notwithstanding the fact that there are, and have been, some high quality, non-state owned banks and corporates in Russia, it is hard to see past the Russian government’s centralising instinct, and its controversial foreign policy decisions, which have rebounded heavily on the Russian economy in the form of sanctions. These factors act as a persistent drag on the investment case for Russian debt.
As emerging market debt is often driven by, or linked to, commodities – oil & gas, metals & mining, agricultural commodities, and the like – and as the production of these very often has a lasting impact on geographies and populations, the questions of environmental and social factors should not be ignored, either.
For example, investors in credits exposed to Nigerian oil and gas should be aware of the controversial history of foreign involvement in the Nigerian energy space. Whether it is the industry’s environmental impact, its record in employing locals, or the imperfect nature of contracts signed, the sector is steeped in environmental and social challenges that, from our perspective, significantly raise the bar for investment in it.
More constructively, it can be argued that a positive example of social change is currently to be seen in Saudi Arabia. Under the new Crown Prince, steps are being taken to ease restrictions on the country’s large young population. These include the easing of segregation between sexes, investment in entertainment venues and the marginalisation of the religious police. There is no doubt that Saudi Arabia faces multiple challenges of other sorts under Mohammad bin Salman – a still heavily oil-dependent economy, an aggressive foreign policy, among others – but the steps being taken undoubtedly strengthen the investment case for Saudi Arabia.
It is very important to stress that questions of governance, as well as social and environmental challenges, are far from black and white issues in emerging markets. Politics are imperfect; social norms vary widely; economies are resource heavy. Indeed, an attempt to enforce a ‘one size fits all’ approach to these matters in emerging markets would be both ill-informed, and a mistake. That said, at Kames we closely consider these factors when buying emerging market bonds. In emerging markets, numbers have always been only half the story.
It has been long expected, but its happening still caused meaningful price dislocation. Two weeks ago, President Maduro of Venezuela announced that the country would restructure its debts. As a result, so far this month Venezuelan dollar bonds have delivered an -18.5% return.
At the start of the month, even though they were already trading at an average price of 46c/$, these bonds still made up a meaningful 1.8% of the flagship emerging market dollar bond index. So even if you were only neutral Venezuelan debt, the past couple of weeks have cost you a decent clip of performance.
Kames doesn’t own any Venezuelan debt, and here’s a few reasons why:
- Debt restructurings are massively complex…: That Mr Maduro tasked his Vice President, Tareck El Aissami, whom the US sanctions as a drug trafficking kingpin, to lead negotiations on the Venezuelan side, betrays the Chavistas’ woeful under-estimation, and probable misunderstanding, of what they are trying to achieve.
- … and Venezuela’s looks like being the most complex of all: More important than individuals, though, are the US financial sanctions currently aimed at Venezuela. Yet, very many Venezuelan bondholders sit in the US, and a great deal of Venezuela’s oil, its lifeblood, is sold to US buyers. Restructuring under these circumstances seems practically impossible. And what about all the other creditors (international airlines with trapped dollars, for example) eyeing this situation with interest?
- Domestic politics offers little upside: While Mr Maduro and Chavismo currently appear to hold the upper hand in Venezuelan politics, if the regime collapses, it’s unlikely that that which follows it would be nearly as assiduous in servicing its debts. In particular, if the IMF became involved alongside a new regime, expect it to take a dim view of international bondholders. And if the current regime survives? Expect more of today’s confusion.
- China and Russia: Both are meaningful lenders to Venezuela. The opportunity for Russia, in particular, to keep the Maduro regime in power, and its debt servicing (barely) current, may be too good to pass up. It can thus get one over on the US, and its investors, on territory ‘close to home’. Sovereign actors with very different motivations and understandings could lead this situation to bump along the bottom for some time.
All that said, eventual recovery values for Venezuelan dollar bonds may well prove to be higher than the levels at which they trade today (in the 20s and 30s). However, both the pathway and timescale to these higher values are highly uncertain – arguably, impossible to read.
If your fund manager holds Venezuelan debt, he or she must think differently. We note that JP Morgan has said that Venezuelan bonds will remain in its emerging market sovereign bond indices, despite default. Could it be that, despite all the opacity and uncertainty around the situation, fund managers are too scared to take a view, and some benchmark risk, here?
From our perspective, we think there are currently plenty of other, more decipherable, investment opportunities across the emerging market debt universe. Venezuela doesn’t pose contagion risk to the wider asset class, we think, so we remain happily pursuing these opportunities.
One paradox of investing in emerging market debt is as follows: very often, those outside the asset class, when criticising it, fail to differentiate between sovereign and corporate borrowers. At the same time, those within the asset class probably don’t think sufficiently about the two investment themes together. Let me explain what I mean.
Firstly, when those who criticise emerging market debt aren’t sure which sort of borrower they’re talking about. In this instance, it’s fair to say that this is not a mistake that these otherwise well-informed people would make when talking about developed market fixed income! To these critics, all emerging market debt is the same. This is, at quite fundamental levels, not the case. Consider the following few facts: emerging market private sector debt as a percentage of GDP is over twice the level of emerging market general government debt as a percentage of GDP. Simultaneously, emerging market private sector debt is overwhelmingly made up of bank lending to corporates and households, as opposed to debt raised in the bond markets. And in both cases, emerging market government and private sector debt is overwhelmingly domestic.
All this puts a few holes in some of the usual shibboleths about emerging market debt. For example, that emerging market sovereign and corporate debt profiles are one and the same. Or, that emerging market corporates have made the entirety of their liabilities (dollar) bonds, owned by foreigners.
What about those inside the asset class? As the emerging market fixed income universe has grown greatly in scale in recent years, investors in the space have become increasingly isolated, as either specialists in one investment theme or the other. However, if you want to buy an Argentine corporate, for instance; you should be sure to have a firm view of what’s going on with the Argentine sovereign. Surprisingly often among emerging markets investors, this isn’t the case.
At Kames, we invest across emerging markets sovereigns and corporates, and aim to marry a clear-eyed view of the top down, with a firm understanding of the bottom-up. This holistic approach also involves tackling some of the widespread misunderstandings about emerging market fixed income as a whole.
China has been in the news a great deal this week, with the announcement, at the Communist Party’s quinquennial Congress, of the next cadre of leadership alongside President Xi Jinping.
However, China did something else significant this week too, and even more infrequent than a once every five year event, although it attracted considerably less attention. The country issued its first sovereign bonds denominated in U.S. dollars since 2004. Eventually priced at 15bps over the U.S. Treasury curve at the five year point, and 25bps over the U.S. Treasury curve at the 10 year point, the new deals represented competitive pricing for the Chinese sovereign. Of course, with each deal capped at $1bn in size, and given the infrequency of China’s appearances in the dollar bond market, the new bonds enjoyed considerable demand. The order book across the two deals was over $22bn in size.
Why did China, a country with over $3 trillion in reserves, need to borrow $2bn? Well, it didn’t. The intention of these new bonds is almost certainly to support the pricing of the existing dollar debt issued by China’s many and varied SOEs (state-owned enterprises).
Unlike their sovereign, these SOEs are not shy about coming to the market. At the last count, some $75bn of Chinese quasi-sovereign bonds were to be found in the main EM dollar-denominated sovereign debt index. With spreads of these issuers trading, on a simple average basis, at around 90bps, China will feel its new sovereign bonds can reduce their borrowing cost. After all, SOEs in regional peer South Korea can trade as tight as 20bps over their sovereign.
The new deal makes sense then, though legitimate questions can be asked as to what extent a $2bn of bonds can, by themselves, deliver fair pricing for an $11 trillion dollar economy. All the same, we expect Chinese SOE bonds to enjoy pricing support as a result of this transaction, and unlike the sovereign, the SOEs will keep on issuing…
A couple of weeks ago, finance ministers, central bank governors, and other interested parties, including lots of emerging markets-focused investors, gathered in Washington, D.C. for the IMF and World Bank Group’s Annual Meetings.
Listening to speakers, and talking to other investors, a couple of my key takeaways from the meetings would be as follows:
Firstly, it’s a constructive time for global growth. The major emerging economies are growing, led by China, but backed up by recovery in the likes of Argentina, Egypt, and Russia. On Europe, there is widespread optimism for the first time in a number of years. In the U.S., the IMF does not make any assumptions in its forecasts about the positive benefits of likely tax reform. Finally, and critically for emerging markets, in this benign growth environment, commodity prices are expected to remain supportive.
Where, though, are the risks? Somewhat to my surprise, these seem to pivot on geopolitical issues, principally those involving the U.S. For example, the state of NAFTA negotiations can only be described as fragile. At the same time, U.S. – Russia relations seem to be at multi-decade lows, as the Trump White House has abandoned ship on the matter. What implications does this attitude have for the Iran nuclear deal, for example? All this, of course, before we mention North Korea.
Perhaps geopolitical concerns can be overstated for markets, and investors should stick to their knitting and traditional fears! However, the extent of geopolitical uncertainty currently engendered by the White House was striking to me. It certainly puts into sharp relief the old idea that political risks in emerging markets are greater than those to be found in their developed market peers.
At a well-attended investment bank research conference on emerging markets last week, a noteworthy chart on show displayed returns across various asset classes over the year to date. In this chart, six of the top ten asset classes were from EM.
Well out in front of the pack, at +27.9%, was EM equities. EM local markets in USD terms returned 14.0%, and our principal indices, EM sovereigns and EM corporates, both in hard currency, returned 9.3% and 7.4%, respectively. The latter was just outside the top ten.
These numbers trumped developed market indices: US HY has returned 6.9%, and US IG 5.3%. In Europe, the numbers were 5.5% and 1.2%.
It’s fair to say that at the start of the year, many people didn’t see such strong performance in emerging markets coming. The pending Trump presidency cast a shadow over EM, and caution was widespread.
Fortune, however, favoured the brave. Since that time, growth across emerging markets has surprised to the upside, led by China, while the Trump presidency has proven to be strong on tweeting, and less strong on delivery. The dollar has lagged.
We think that this is not just a phase, and that emerging markets are poised for continued performance. Some emerging economies were badly burnt by the commodity sell-off, but came back more resilient – growth is now picking up across EM; valuations are superior to those in developed markets, where post-crisis interference has smothered yields; finally, inflows to the asset class provide a renewed and supportive technical.
As ever, the picture is far from perfect: South Africa looks like it will get worse before it gets better; Venezuela is teetering on the edge. However, the overall picture is undoubtedly a constructive one, and against this backdrop, we see widespread opportunities across the emerging market debt space.
The market continues to fear that the strength is about to turn over. We think the greater risk to investor positioning is that it persists.
To many in the UK, Dubai is best known as a tourism and entertainment hub, perhaps a good bet for some winter sun. Its role as a leading global trading centre is less well known. However, it is the latter aspect of Dubai which is, we think, both the most important and interesting part of its story.
Global ports operator “DP World” epitomises this element of Dubai. Having begun with one asset in Dubai in 1972, the company today operates 78 terminals across 40 countries. In 2016, it handled 64 million TEU (twenty-foot equivalent units), the ubiquitous, work-horse containers of global trade.
We like this company, not least for its core role in Dubai, and its strong global diversification. Its long end bonds have this year performed particularly strongly. However, for the general observer, it is DP World’s experience of and take on global trade that is most interesting.
Yesterday, the company reported its first half results, and the read-across is solid. Firstly, consolidated volumes of TEU were up by +4.7% YoY on a like for like basis. Secondly, performance in the company’s three major regions was healthy. In the Middle East, Europe, and Africa, volumes increased +4.2% YoY, driven by the UAE and the UK. In Asia Pacific and the Indian Subcontinent, volumes increased a respectable +2.9% YoY. Finally, in Australia and the Americas, volumes gained +13.5% YoY, driven by the latter region.
This sound performance is, importantly, expected to be maintained in the second half of the year. This augurs well for both emerging and developed economies, and also serves to highlight, once again, Dubai’s under-appreciated role as a key link in global trade.
Experience would tell you that, in the current dispute between Qatar and its neighbours, cooler heads on both sides would prevail soon enough, and the situation in the region revert to normal. However, reviewing the list of demands made overnight by Saudi Arabia and its allies of Qatar provides good reason to think again.
In short, the list of demands is steep, and so it is hard to imagine Qatar engaging in the necessary set of climb-downs that acquiescence would entail. Among the demands is found: Qatar shutting down Al-Jazeera; ending military co-operation with Turkey; paying repatriations; and, best of all, facing ten years of annual compliance monitoring!
Qatar is supposed to agree to all of this within ten days. As one set of mostly very wealthy nations faces off against another, very wealthy, nation, what seems more likely is a medium- or even long-term stalemate. This, both sides can probably manage: certainly, nobody in Qatar is going to go hungry as a result of any current blockade.
The implications are probably more troubling for EM investors’ sense of the region. GCC (Gulf Cooperation Council) assets have historically anchored many an EM portfolio: these are wealthy, stable, well-run economies, after all.
Perhaps not. With a millennial Crown Prince in charge in Saudi Arabia; with oil threatening to break out of its 1Y range to the downside; and, above all, with a far from steady hand on the tiller in the White House, it is not clear if the GCC should, any longer, be taken as the hallmark of stability it once was.
As I said above, we shouldn’t be surprised if a face-saving way out of the current impasse is found, and the GCC thus reverts to type. But at first glance, this morning’s rather surprising list of demands suggests that this time could be different. Investors should prepare accordingly.
It’s a difficult time to like EM corporate bonds.
In the first instance, valuations are expensive. In fact, emerging market corporate bonds now trade at a tighter spread than emerging market government bonds.
Source: JP Morgan. CEMBI is the EM corporate index, EMBIG the EM sovereign index.
In addition, the greater part of the build-up in leverage in emerging markets in recent years has been on private balance sheets, not on those belonging to governments.
At Kames, our focus is on those stronger sovereign balance sheets. However, we can and do buy the debt of emerging market companies when individual credits’ valuations and fundamentals are attractive. It’s a highly selective approach that takes advantage of price dislocations and disruptions – a necessary approach, too, in what has become an expensive corner of the market.
On Friday morning President Zuma of South Africa dismissed his Finance Minister and Deputy Finance Minister. Such a move had seemed likely after the highly unusual decision to call back the two ministers from a roadshow in London earlier that week.
Finance Minister Gordhan enjoyed a strong measure of market confidence, in a country where institutional strength has been seen to be in short supply. As such, his sacking represents a real blow to South Africa’s credibility.
Over the course of last week the rand sold off approximately 8% against the dollar. The spread on South African dollar denominated sovereign bonds, as measured by JP Morgan’s EMBIG Diversified index, moved from +239bps to +269bps over the same period.
We would not step in here, however. The currency’s sell-off still leaves it inside the one-year average of 14 rand to the dollar, and well inside the one-year high of 15.9. As for bonds, we expect South Africa to now lose its investment grade ratings from at least two of three ratings agencies. South African paper should therefore trade closer to BB rated Turkey (+314bps).
Overall, the decision to sack Mr Gordhan reveals the high stakes around the battle for power in South Africa this year. As the African National Congress gears up to choose its next leader later this year, the issues surrounding President Zuma’s controversial time in power seem to be coming to a head, as he battles to secure his position and legacy.
With little clarity around how this probably destructive endgame might play out, and value set to leak further in South African assets, we prefer to be on the sidelines here.
China has seen elevated credit growth since the global financial crisis, such that investors consistently raise this issue as a core concern for emerging markets. The more recent rise of President Trump has also added to the pressure on the world’s second largest economy. A recent visit to China for a number of meetings with economists, academics, and policymakers, has helped develop my thinking on these key topics.
The watchword for China this year is stability. The 19th party congress this autumn, where President Xi Jinping will seek a second term as General Secretary, while various other senior members of the party also jockey for position, means that the energies of the state are principally focused on avoiding any unforeseen disruptions. That includes to the economy.
Thankfully for the party, China’s economy is in something of a sweet spot right now. A commodity upswing, trade strength, and government-backed investment demand should see the 6.5% growth target for 2017 comfortably met. At the same time, the PBoC seems able to raise its policy rates, in order to push back at some of the smaller banks’ funding models, without raising its more important benchmark rates.
When it comes to President Trump’s views on China I believe that, for this year at least, his bark will be worse than his bite. A fully blown trade war between the US and China serves neither side’s overall interests. We might well see some tit-for-tat tariffs introduced, but the broader relationship should remain on course. We may even see some ‘gives’ from China at next week’s meeting of the two leaders in Florida.
Over the medium to long term, however, my view of China is somewhat bleaker. Firstly, it is doubtful that China can somehow dodge economic gravity, following its dizzying rise in debt to GDP: a banking crisis or major growth shock will probably come to pass. Secondly, real estate continues to play too great a role in the financial accounts of Chinese local governments and individuals, and indeed in national growth targets. Thirdly, Chinese SOEs continue to play a distorting role in the Chinese economy, and the current leadership does not seem minded to engage in serious reform on this, or related matters.
I am mindful that the contradictions of a ‘socialist market economy’ mean that China could well keep the show on the road for longer than we expect. Equally, genuine growth upturns in China and Asia should not be ignored by market participants when they occur. But with the above questions on leverage outstanding, allied to the challenge facing China in reforming its impossible trinity (of rates, currency, and capital), a crunch moment seems likely in the next few years.
Monday morning sees our Fixed Income team sit down and thrash what’s what for markets. We assess how our positioning has fared and should it change.
In the debate this morning one of the managers quipped “If you are going to invest in a country with a crazy dictator, you may as well get paid for it” – while discussing the relative value between the US and emerging markets.
This blog doesn’t aim to proffer views on US politics; however, there is no doubt that the Trump era is very different from the Obama regime. So I wondered how EM had faired since the start of 2017.
For the US Treasury market, yields have rallied by just over 10bps using the US 10 year note as a gauge. Overall returns would have earned you a further 2 months of its 2.25% coupon. All in all you’d be up around 1.5%. So my colleague was right – a generic investment grade Emerging Market index has done double that so far this year – just over 3%.
“You are mixing your metaphors” I hear you say – mixing your Sombreros with your Stetsons. It is an observation but it is clear that what happens in the US materially effects EM. Immediately after Donald Trump’s election, markets for all the obvious political reasons, became very bearish on EM. However, as the dust has settled there is a realisation that things aren’t changing overnight and that the Federal Reserve isn’t raising rates as aggressively as some had expected. Clearly there is more to relative value between the US and EM, but so far this year looks likely to repeat some of the key themes for 2016: any softness in the US interest rate cycle is likely to be good for EM economies.