Emerging Market Debt: An End To The Agony? by Jim Cielinski, Columbia Threadneedle Investments
- Capitulation by many EMD investors has created opportunities in many of the more resilient countries.
- We favor countries moving down the reform path and where there is significant impetus to reign in excessive government spending.
- Valuations have reached the extremes that allow a selective approach to EM to now represent a key part of an income-oriented portfolio.
Emerging markets (EMs) have endured a miserable year. Slowing Chinese growth, collapsing commodity prices, rising indebtedness and geopolitical turmoil have all taken their toll on fundamentals. The worsening EM story has, in turn, had a negative impact on capital flows, impacting performance both in absolute terms and relative to developed markets.
More recently, China’s devaluation has led to fears that deflation could be exported to the rest of the world. The haphazard nature of China’s policy response to the economic downturn has weakened investor resolve that Chinese authorities can engineer a “good” outcome. The problems do not end there. The Federal Reserve is stating a desire to tighten policy, prompting concerns that a continued rise in the U.S. dollar will undermine EM local returns.
Unsurprisingly, sentiment toward emerging markets has soured. The above trends are self-reinforcing, prompting many to call for EM to enter a protracted period of weakness. Given all the uncertainties, should investors simply ignore EMD altogether, or might a more selective approach to EMs produce better results?
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It is far too late in the cycle to “give up” on emerging markets
Abandoning EMD altogether is akin to throwing the baby out with the bath water. The adjustment in EM assets is hardly new, and underperformance has been marked since at least 2012. Consider Brazil — a constant source of discouraging news. Brazilian equities, as measured by the Ibovespa, are down by 36% over the five years ending September 30 in local terms. For a U.S. dollar investor, however, depreciation of the Brazilian real has pushed the return to -71.7% over the period. Local rates in Brazil have risen to over 15%. Other markets — in USD terms — have also posted deeply negative returns. Russia, Ukraine, Turkey and Argentina have all endured periods of notable stress in the last 24 months.
Prices could, of course, move lower, but valuations suggest that EM challenges are well-recognized in the market. We fully expect a protracted period of emerging market economic weakness, but we are at a stage in the current cycle that demands a focus on dislocations and valuation. Many opportunities appear compelling. EM growth will be positive and will continue to exceed developed market growth (Exhibit 1), notwithstanding the risk of further downward growth revisions that have dominated this cycle (Exhibit 2). This is a recipe for further volatility, despite much-improved valuations.
Exhibit 1: IMF GDP growth forecast — advanced economies
Sources: Columbia Threadneedle Investments, IMF, 07/15
Exhibit 2: IMF GDP growth forecast — emerging economies
Sources: Columbia Threadneedle Investments, IMF, 07/15
It’s a different kind of EM crisis
In the 1990’s, EM stresses were amplified by fixed exchange-rate regimes. By pegging exchange rates to the U.S. dollar, countries sought to mitigate economic and trade volatility. As growth and inflation exceeded levels in the U.S., however, it also had the effect of encouraging borrowing at abnormally low real rates, most often in U.S. dollars. Initially, this credit creation provided a tailwind to growth. Much of it was unsustainable, however, and ultimately the excessive credit creation would leave sovereigns heavily indebted and exposed. As growth slowed, currencies would no longer be consistent with a manipulated fixed rate. External lenders would inevitably grow concerned about toxic levels of real borrowing and cut off funding. Defaults on external debt were a common “end-game.”
Today’s fundamentals are different. Few countries have fixed exchange-rate regimes and sovereigns have not recklessly ramped up leverage. The relief valve today is the exchange rate. Emerging market currencies have now fallen 34% from their peak levels of the post-crisis period and are trading at their lowest levels since 2007 in nominal terms. For dollar investors, this already qualifies as an “effective default” — losses not associated with a traditional “lack of payment” but rather with a debasement in currency. This explains why external debt returns (i.e., “hard currency”) have been respectable in the current cycle, although foreign exchange (FX) returns have been dire (Exhibit 3). The carnage has certainly not been limited to currency, however. Local rates in most markets have moved higher, in many cases sharply underperforming developed markets (Exhibit 4).
Exhibit 3: EM excess returns vs. EM FX (against US dollar)
Sources: Bloomberg, JPMorgan, Columbia Threadneedle Investments, 09/15
Exhibit 4: EM local rates
Sources: Macrobond, Columbia Threadneedle Investments, 09/15
It is fair to deem these types of returns as indicative of a modern-day EM crisis, but this crisis will have a different ending. Something must be done to break the self-reinforcing downtrend of weaker growth and falling currencies, which prompts further capital outflows and tighter domestic policies via higher interest rates. It will not be easy but there is hope on the horizon.
An emerging market rebound — in search of an elusive catalyst
There have been numerous false bottoms in EM over the last three years. Identifying a catalyst for a turnaround first requires an understanding of just how the mess was created. Overall EM growth is slowing materially, but GDP growth in the healthier EMs will remain positive — even excluding China. While Chinese GDP growth is indeed decelerating, we believe it is not likely to drop below 4.5%, as such an outcome would most likely require policymakers to sit on its hands and watch the economy implode. This is inconceivable given the significant foreign currency reserves and policy tools at their disposal. Real interest rates in China are still very high, and fiscal policy could be used to support growth.
Despite the glimmers of hope in China, the path for EM is rocky and there are simply no easy solutions for their ailments. Most emerging economies have lost their ability to set monetary and fiscal policy. China still occupies a position of “policy maker.” Other countries are “policy takers.” They cannot ease because their currencies are weak and inflation accelerating. They cannot tighten because real growth is stumbling. They cannot boost fiscal policy simply because most have already overspent. These countries will remain mere passengers on a policy train driven by the U.S. and China.
Currency debasement is an oft-recommended but highly inexact “solution” to export woes. Soft exports are only one part of the EM economic malaise. The degree of devaluation necessary to significantly spur export growth is unclear, especially in light of the meager response to the already large currency adjustments. The root of the problem is that global demand is soft. Developed market demand has downshifted, and there is simply not enough export demand to lift all emerging economies. Moreover, the approach is undermined if other countries pursue similar devaluation policies. Most importantly, though, is the fact that currency debasement raises the price level, dampening real incomes and consumption. The slight benefit accrued by exporters is more than offset by a sizable drag on consumers.
The underlying issue for many EM economies has been inefficient investment. For at least the last five years, the corporate return on capital and return on equity have fallen sharply (Exhibit 5).
Exhibit 5: MSCI EM Index — return on equity and capital
Sources: Bloomberg, MXEF Index, Columbia Threadneedle Investments, 09/15
This picture masks growing imbalances. Emerging economies have invested heavily in additional capacity but fueled by low real rates and misguided policy, this investment has frequently led to misallocation of capital and poor returns. Post-GFC stimulus was initially reflected in stronger growth. As that growth has faded, the hangover has set in. Governments are finding it difficult to reign in the spending that it many cases helped to transform societies. No one wants to feel as though they are relinquishing the gains of the EM “golden decade.”
Another key issue has been an explosion in EM private debt growth. This cycle has been characterized not by sovereign leverage but by heavy borrowing by a full range of non-sovereign borrowers such as agencies and corporations (Exhibits 6 & 7).
Exhibit 6: Private credit, broad definition
Sources: JPMorgan, BIS, IMF, Columbia Threadneedle Investments, 09/15
Exhibit 7: Broad credit growth
Sources: JPMorgan, Columbia Threadneedle Investments, 09/15
Much of this growth has emanated from Asia, much of it in the banking sector. Growth in private sector debt has in many cases pushed levels well above 100% of GDP. The risk of an immediate debt service crisis appears limited, but if there is a payments issue brewing, this is where it will originate.
Idiosyncratic risks in EMs appear as high as they have ever been. There are the obvious examples such as Russia and Brazil, but even countries which are beneficiaries of the commodities rout — such as Turkey — are struggling because of geopolitical concerns. Simply operating on the basis that EM commodity exporters (e.g., Chile) are bad and EM commodity importers (e.g., Turkey) are good is not a viable approach in a world where EMs are increasingly differentiated and subject to idiosyncratic risks. Indeed, ‘EM’ might be a convenient form of shorthand for anything that is not a developed market, but little more.
Managing idiosyncratic risks
This is perhaps the biggest challenge for EMD investors. The identification of idiosyncratic risks requires much hard work, as often the events that move markets tend to be the “black swans” or “unknown unknowns” that investors do not have on their radars in the first place. This makes thorough research and an understanding of what is happening at a macro and micro level all the more important. The turmoil in Greece (a “quasi-EM”) has been contained because markets trust the ECB to do “whatever it takes” to keep the euro project alive and limit contagion. By definition, the outcomes in countries such as Brazil, Russia and China are much less certain. This is partly because the authorities and their policy responses are much less transparent, and also because the risk of an accident somewhere in emerging markets is rising given what has happened to commodity prices and EM exchange rates. There are viable strategies to pursue.
Be cautious of EMs with dwindling FX reserves and limited ability to cover external financing needs. EM FX reserves have fallen as EM trade balances have been hit by lower commodity prices and weak manufacturing demand. Moreover, outflows and the need to hedge existing foreign positions have boosted demand for FX liquidity from EM central banks at a time when U.S. dollar liquidity has been reduced by the Fed stepping back from QE. China’s recent FX reserve declines — part of efforts to stabilize the yuan — may well have dominated headlines, but the phenomenon is more widespread. China has an enormous stock of reserves and is not in danger.
Watch for country-specific political developments and policy surprises. Ukraine had restructured its debt and fighting continues between the government’s own troops and Russian separatists, with no end in sight. In Brazil, it is possible that the president could be impeached and that a political impasse will prevail in the interim. It is also worth remembering that Petrobras, the embattled Brazilian oil company, is still the largest individual corporate issuer of dollar debt in the marketplace. Turkey has been without a formal government for six months. There will be other challenges in other countries and investors will need to ready for them as internal stresses multiply.
Maintain flexibility within an investment approach. EM bond indices are rapidly evolving as constituents are upgraded and downgraded. Agencies are lagging indicators, however, and often move well after credit quality and market prices reflect the deterioration. Both Russia and Brazil have watched their investment-grade ratings disappear this year by at least one agency. Turkey’s IG rating status is under scrutiny as the heightened political volatility and intensification of the Kurdish conflict have raised further concerns among rating agencies about the predictability of policymaking. Conversely, Indonesia and the Dominican Republic could be exceptions as they appear determined to enhance credit quality. Hungary also looks set to regain its IG rating status in the medium term. Our advice is to forget the ratings and focus on fundamentals and valuation.
The wildly disparate stories across the sector highlight that treating EMD as a homogenous bloc is at best simplistic and at worst dangerous. Understandably, many are worried that we may be poised for a re-run of the 1997 Asian financial crisis, given the volatility and the policy announcements that have emanated from China in recent weeks.
A road full of potholes and opportunities lies ahead. Differentiation will be critical. We believe a re-run of the type of crisis witnessed across Asia in 1997 is unlikely for the following reasons:
- Growth fundamentals are stronger, and banking systems are stronger and better insulated than in 1997. Furthermore, exchange rates across EMs are now largely market determined, foreign reserves are higher, and current account balances are generally healthier than they were in 1997.
- Asian EMs can better withstand capital outflows than in 1997 or 2008: FX reserves — the most basic gauge of the external balance — and coverage of short-term debt and imports are much higher relative to 1997. Furthermore, Asia’s overall savings/investment balance remains heavily skewed in favor of savings, even though household debt has risen since 2008. Already, loan demand has started to slow across most Asian economies, thereby helping to contain household leverage ratios. FX reserve/import coverage ratios in Asia, for example, are generally healthy. Korea and the Philippines are 4-5x better covered than in 1997 while coverage in Malaysia and Taiwan has doubled. FX reserve/short-term debt coverage — a major vulnerability in the 1997 crisis — has also improved considerably. In 1997, many countries in EM Asia could barely cover their short-term debt with FX reserves, whereas coverage now ranges from 2x to 8x, except in Malaysia. Crucially, no Asian economy has short-term debt that exceeds its foreign reserves.
EM growth will remain depressed and in many cases slow further. Performance across countries will diverge significantly, but we do not expect the EMD asset class as a whole to crash-land. There are good stories and bad stories, and investment success will be determined in large part by focusing on the former and avoiding the latter.
Seeking reform and positive returns
The issues EM countries face today are structural in nature, although they are being amplified by a prolonged negative cyclical environment. In the short term, these markets can and likely will be aided by friendlier policy expectations in both the U.S. and China. This is likely to allow the search for yield to perhaps trump risk aversion and push prices higher. For any rally to be sustainable, however, something more is needed. EM economies must become more self-sufficient. This requires greater consumption in those economies with high savings. For those commodity-sensitive economies now running large current account deficits, there is little outside of demand deflation and structural reform to improve competitiveness that appears viable. This will require a solution that most will find politically unpalatable, making it very difficult to execute in regions dominated by populist leadership. The impact will not be felt immediately, making this will be a long, drawn-out process for some countries. There is more pain and adjustment to come.
Many of the stories we see today appear more positive for local debt markets than equity markets. In many countries, real levels of rates and currencies appear to have substantially adjusted. If a payments crisis can be avoided, slower rates of real growth should ultimately generate lower rates. In our minds, the appropriate strategy is to emphasize those countries most willing to accept structural reforms and take the tough medicine.
Many EMD investors have capitulated. Outflows have been sizeable in 2015. Although not a reason in itself to buy EM debt, it has created opportunities in many of the more resilient countries. We favor those countries that are already moving down the reform path, such as Mexico and India. We also favor countries such as Indonesia, where there is significant impetus to reign in excessive government spending. Hungary and the Dominican Republic have turned the corner. Russia, as a riskier play subject to oil price volatility, may also be on the verge of seeing growth and capital outflows reverse. Some of the riskiest countries, such as Argentina, may also be on the cusp of improvement following a long period of duress. Other countries, such as Poland, Taiwan and Korea, remain in relatively good shape from a credit perspective but suffer from more expensive valuations.
As economic and policy divergence grows, so will volatility, creating numerous investment opportunities. A credible one-size-fits-all solution for the entire EM class is simply not in the cards. There is little momentum in reform agendas, and many countries are not yet ready to jettison populist politics, making it unlikely that painful but necessary policies will be adopted. Investors, however, must recognize that a lack of generic strength is not a prerequisite for producing attractive fixed-income investment opportunities. A selective focus on those economies that have been unfairly tainted now offer value. Valuations have reached the extremes that allow a selective approach to EM to now represent a key part of an income-oriented portfolio.