Market Views: Fixed Income
Outlook 2018: Emerging markets debt absolute return
Although global liquidity tightening presents a significant challenge to emerging markets, we believe a select number of local currency debt markets are still attractively valued.
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Emerging markets (EM) hard currency debt has already experienced what appears to be an overextended bull market. EM local bonds and currencies have also rebounded strongly from the oversold levels reached in early 2016. The key question for investors is whether these positive trends can persist in 2018.
Global liquidity tightening a significant challenge to EMD
The tightening in global monetary conditions is the most significant challenge facing EM debt in 2018. The US Federal Reserve has already shown some determination to step up its monetary normalisation process and there is a distinct possibility that this may soon turn out to be a late cycle tightening.
As shown in Chart 1, our measure of global financial liquidity has already experienced a sharp deceleration this year, which we tend to consider as an early warning indicator that a setback in global financial markets is in the offing.
This liquidity tightening is exacerbated by the apparent resolve of the Chinese authorities to tackle the unsustainably high level of debt in the nation’s financial system. In this regard, the recent mini cyclical recovery in China appears to have already passed its peak. The delayed impact of the various tightening measures implemented in 2017 and a renewed push for “supply side reforms” could soon reignite concerns about China’s debt dynamics. Chinese policymakers are demonstrating for now a strong ability to control the renminbi exchange rate but we should remain wary of any signs of reescalation in capital flight.
Chart 1: Global liquidity measure
(based on global real M2 growth)
Poor outlook for EM hard currency debt
This global liquidity environment is particularly challenging for EM hard currency debt. We remain of the view that this sector exhibits an unappealing mixture of expensive valuations, heavy positioning by market participants and increasing illiquidity. Therefore, investors with a particular focus on capital preservation should reassess their exposures to EM credit markets as these have been one of the biggest recipients of the gigantic “carry trade” created by the ultra-lax monetary policies of recent years.
The average EM external debt yield, as measured by the JP Morgan Emerging Markets Bond Index Plus (EMBI+), is currently at 5.8%, of which the defaulting Venezuela alone is contributing 1.2%. As can be seen in Chart 2, the EMBI+ yield experienced its first leg higher during the taper tantrum of 2013 and has since been in a consolidation range. A potential break higher through the top of this range (6.5%) is needed to confirm a switch from a bull to a bear regime for EM hard currency debt.
Chart 2: EM hard currency debt yield
(JP Morgan EMBI+)
Select local currency debt markets still attractively valued
While EM hard currency debt appears to be priced for perfection, selected local currency debt markets still offer value. We believe that high yielding local government bonds in countries which have recently undergone macro-economic adjustments could generate a strong return in US dollar terms in 2018 from a combination of yield, bond price gains and currency appreciation.
To achieve these returns, there will be a particular focus on countries such as Argentina, Brazil, Mexico, Russia, South Africa, India and Indonesia. These countries still offer relatively high levels of yields, improving external accounts and, with inflation brought under control, their central banks can continue to withdraw the aggressive monetary tightening implemented during the balance of payments crises of 2013-15.
What we particularly like about these countries is that they have followed what can be described as a predictable and credible trajectory with regards to their recent crisis resolution. Chart 3 below illustrates what we consider to be the four key stages of the long-term economic cycle in EM. We believe that the countries highlighted above are now in a good position to reap the growth benefits of the adjustments they accomplished in the aftermath of the balance of payments crises of 2013-15.The “adjustment phase” of the cycle is well advanced and there is already tentative evidence that these countries are moving into the “equilibrium phase”.
Chart 3: The EM economic cycle since 2002
For this reason, we believe that the recovery in a number of EM currencies that appears to have started in early 2016 is still in its early stages, as shown in Chart 4. The improvements in trade balances that these EM are still experiencing and the relatively attractive level of their real effective exchange rates bodes well for further currency strength in 2018.
Chart 4: The recent recovering in EM currencies is still in early stages
(JP Morgan EM currency index)
Potential for politics to create volatility
While the economic cycle in our favoured EM is in its positive phase, the same could not be said about their political cycles. Brazil and Mexico will be facing presidential elections during the second half of 2018. South Africa is currently experiencing a volatile transition as the governing African National Congress Party is deciding who will succeed Jacob Zuma, the current controversial president. Politicians in Indonesia and India will also soon start the manoeuvrings ahead of the general elections scheduled to take place in both countries in 2019.
These potential political tensions could create volatility in the next 12 months, which will need to be managed by scaling back exposures when required. However, our favoured EM are now better equipped to withstand these political uncertainties, especially given the adjustments and the improvements in growth prospects highlighted above. We also remain of the view that the electorates in these countries could reward leaders with good reform credentials. This has already been illustrated in Argentina, where President Macri has won the recent mid-term elections, thus reinforcing his ability to pursue his reform agenda.