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.