We recently attended the International Monetary Fund (IMF) spring meetings in Washington D.C. We had the opportunity to engage with various policymakers, investors and IMF representatives across frontier markets. The experience left us with the impression that the recent performance divergence across frontier local and hard currency markets could continue given the spectrum of fundamentally differing credit stories.
Signs of strength and stability
These are countries generally under an IMF programme or alternatively where we have seen a dramatic and sustained improvement in imbalances which we expect to continue over the next 6-9 months. Countries in this group included Ghana, Egypt, Nigeria, Ivory Coast, Georgia and Mongolia.
Ghana remains supported by an IMF programme, and benefits from strong group of competent technocrats within its government. Growth looks like it will remain strong, while increased oil production will help limit the impact of any increase in growth related imports on the current account. In addition, declining interest rates will also help the deleveraging process.
Egypt remains a favourite among investors and the IMF alike. It is performing well under the IMF’s US$12bn programme and ‘green shoots’ of growth are appearing.
The primary fiscal (government annual budget) balance is expected to move towards a 2% surplus in 2019, while exports from the Zohr gas field will help sustain improvement in the current account.
After a tough few years, the worst seems to be over for Nigeria, at least in the short term. With oil prices above US$65 and oil production stable, the country is now running a sizeable current account surplus. Meanwhile, declining inflation will allow the central bank to ease rates over the coming year. Although structural issues remain, the country now has the opportunity and firepower to support the economy.
Signs of improvement
There were several countries where after a period of deterioration in credit metrics we are starting to see signs that data might start to surprise to the upside once again. Countries in this group included Argentina, Costa Rica, Oman and Angola
After a solid stretch of policy and economic performance, Argentina shook investor confidence at the end of last year with a sudden change of inflation target, resulting in an 18% depreciation in its currency.
At the meetings, policymakers clearly expressed that they had learned lessons from how they communicated the policy change. Meanwhile, a weaker currency and stronger growth numbers could easily trigger better fiscal performance than expected and support lower issuance.
In the short term, we expect to see the central bank try and re-anchor inflation expectations, while seasonal flows could also support the stabilisation in the current account.
With the election of President Carlos Alvarado, we are finally starting to see moves to rein in the fiscal deficit which has plagued the country. Recent reforms introduced are expected to cut almost 2.5% off the deficit, while the IMF team seemed to think that this was just the first step towards the 3.5% figure needed to stabilise debt to GDP ratio. Although a move in Congress towards the centre-right bodes well for any package being approved, we will need to monitor the situation closely once the new Congress takes its seat on the 1 May.
Signs of reform fatigue
After a period of improvement in economic data, a few countries are starting to show some signs of weakness. This will need to be addressed in the short term to avoid a build-up in vulnerabilities. Countries in this category included Ukraine and Senegal.
Ukraine’s performance under its current IMF programme has started to wane. This is in part due to local resistance of some of the tougher proposed measures such as increasing gas prices by 40% as well as establishing an Anti-Corruption Court.
Fundamental performance has remained relatively good, with inflation continuing to moderate and the strong current account balance moving reserves above US$18bn. However, given the refinancing risks that remain, Ukraine still require the IMF support.
Signs of fragility
Some countries face debt sustainability issues which are not being adequately addressed and show some signs of fragility. Vigilance is required, as without sufficient action by authorities these countries could face severe difficulties in the future. Countries in this category included Pakistan, Zambia, Ecuador and Venezuela.
With deteriorating fiscal and current account balances, Pakistan is quickly heading back to a situation where it will require an IMF programme to stabilise its finances. It only just escaped from IMF support 18 months ago, yet with an election coming up, we have seen little intent to address the deteriorating level and quality of fiscal balances, deal with the current account deficit or address the overvalued exchange rate.
The credibility of Zambian policymakers continued to erode when the government failed to deal with the issue of large contracted loans, which endanger debt sustainability. They have also failed to propose sufficient fiscal reforms to offset this proposed debt load.
In the meantime foreign currency reserves continue to decline and now sit at only two months of import cover, as external debt payments erode external buffers even at higher copper prices
Vivienne Taberer, Portfolio Manager, Emerging Market Fixed Income, discusses the upcoming elections across Latin America, including the risks and opportunities they present for investors.
Latin America at a policy crossroads
The results of widespread elections across Latin American countries this year will drive policy into the next decade, with six presidential elections on a full calendar that also includes a referendum and several legislative elections. Understanding the political direction of travel, whether it be straight ahead, or veering to the left or right, is likely to give us a much clearer steer on the risks and investment opportunities in the region over the medium term.
Chile and Honduras held elections in 2017, with the legislative elections and the first round of the Costa Rican presidential election and Ecuadorian referendum kicking off the 2018 electoral calendar in February. Colombian and El Salvadorian legislative elections followed suit in March.
While Paraguay and Venezuela also both have elections scheduled for the first half of the year, the market will mainly focus on Brazil, Colombia and Mexico. If the final outcome of the Costa Rican election, relative to polling, is anything to go by, uncertainty is likely to remain high and markets skittish.
Corruption and insecurity exercising voters
Corruption and insecurity are some of the key issues consuming voters against a generally more favourable economic backdrop. This has led to a more anti-establishment focus than would otherwise have been the case, eroding the reliability of polls in predicting election outcomes. Costa Rica provides a cautionary example, witnessing wild swings in the polls and the huge percentage of undecided voters, as conservative values became a key election issue. All this before voters finally re-elected the ruling party candidate in defiance of the last polls which put him way behind.
Three presidential elections in 2018
Presidential elections are scheduled in three of the region’s largest markets, a confluence that only happens once in every 12 years: Colombia, Mexico and Brazil.
Colombia: market friendly candidate ahead for now
Colombia holds its first round on 27 May, followed by a run off on the 17 June if no candidate wins an absolute majority. Centre-right candidate, Ivan Duque, has surged ahead in the polls since the primaries. While it looks unlikely that he can win in the first round, we are encouraged by his current polling. At this stage it appears his main competition is likely to be Gustavo Petro, the left leaning ex-mayor of Bogota. Markets have rallied sharply since the primaries, confident that the market-friendly, centre-right candidate will prevail and the recent political direction will remain on course.
Risk and opportunity in Colombia
Despite the recent good performance in asset prices, Colombian markets still appear well placed to rise higher in the event of a Duque win in the run-off. The centre-right steer in the country seems to be solid and hence our base case is for a Duque win, even if Petro does better in the first round than we anticipate. Given our constructive view, we hold an overweight bias in the peso and the local currency bonds.
Mexico: potentially moving left
Market certainty is also growing in the expected outcome of the Mexican presidential election on 1 July. Though we expect only a modest impact on the investment landscape, the political direction of travel is expected to move to the left, with voter concern about corruption being a major determinant of the shift. Left-leading candidate Andrés Manuel López Obrador, usually referred to as ‘AMLO’, continues to poll very well, well ahead the Institutional Revolutionary Party (PRI) and National Action Party (PAN) candidates, Ricardo Anaya and Jose Antonio Meade. With no second round in Mexico, it appears to be AMLO’s race to lose, with Meade and Anaya within the margin of error and nothing to suggest a strong consolidation of a big anti-AMLO vote behind one of the two.
Risk and opportunity in Mexico
The market seems resigned to an almost certain AMLO win, so the key focus shifts to what impact this could actually have. So far, policy outlined by AMLO appears designed to ease investor concerns, with no radical economic policies referenced in political rallies. In addition, it is highly unlikely AMLO’s party, Morena, will get a majority in Parliament, so it will be difficult to make dramatic changes in any case. So while the direction of travel is not great under an AMLO Presidency and there are long-term risks, in the short time we expect relatively limited downside to the markets should the predicted move to the left prevail. Clearly, significant upside potential exists if either the PAN or the PRI candidate manages an upset. A significant number of voters remain undecided and the presidential debates could well be the key to determining if the political landscape will shift back to the right. Both Anaya and Meade are expected to debate well and AMLO will need to avoid his mistakes of the previous two elections where he veered too far left. We are neutrally positioned in the currency and have moved to longer dated maturities in the local bonds market. There will likely be investment opportunities as volatility increases nearer the election.
Brazil: wide open
In Brazil, the race remains wide open. While there is still the expectation that the centre-right will consolidate behind a single, electable candidate, uncertainty abounds. The first round is scheduled for 7 October, with a run-off on 28 October. Ex-president Luiz Inacio Lula da Silva (Lula) on the left remains ahead in the polls, despite his arrest and the extremely high likelihood he cannot run, while the populist Jair Bolsonaro also polls well, coming in second in voter intentions. With party registrations only just having closed, the number of candidates in the middle remain large and with very fragmented support. Alckmin, the Sao Paulo governor, is the market’s favourite among these candidates but is not polling well .Marina da Silva has improved her polling very recently and seems well placed to capitalise on Lula’s situation.
Risk and opportunity in Brazil
The situation in Brazil remains the most unclear, and this will likely continue until the centre-right consolidates behind one candidate. While there still seems to be a core belief from many market participants that such a candidate will emerge and win, there are too many risks to really back this as a base case for now. Asset prices are likely to continue to react to this uncertainty, especially given broad disaffection with the political establishment among the electorate. One thing is clear though, the pressure for reform will be high for any successful candidate. With most candidates highlighting the importance of social security reform in the new administration, the risk-reward pay-off has made us constructive on the long end of the curve. In terms of the currency, we think it currently doesn’t offer sufficient value and believe there’ll be better opportunities to add given the anticipated pick-up in volatility.
Despite anticipating some election-related noise and inevitable volatility across Latin American markets, it appears unlikely we’ll see a sustained deterioration in the overall political framework. Countries like Venezuela are proving the exception rather than the rule. Consequently we retain our constructive view on the region, particularly given the recent sustained strength in global economic growth. Markets will almost certainly offer interesting investment opportunities along the way, either by a market overreaction or more granular election outlooks.
Last month we attended a trip hosted by CICC in China to gain a deeper ‘on the ground’ understanding of the health of the Chinese economy. This was a commodities and macro focussed trip and the third consecutive year we attended. The government’s reform efforts in reducing excess supply in the economy continue to impress. Upstream industries are in generally much sounder financial health relative to my first trip in 2016, and the reform focus has clearly pivoted away from financial to environmental health, consistent with remarks over recent months by President Xi. It’s widely expected commodity prices should be supported by reduced supply, although shifting attention to cleaning up the environment may have some unintended consequences for demand.
Xi’s supply side reforms keeping the steel market balanced
To its credit, the government’s ambitious attempts to tackle inefficient steel production and revive profitability is clearly working. My visit to Tangshan, one of China’s big steel producing cities, was testament to that with ‘diamond-effect’ paintwork on Range Rovers, Lamborghinis outside the front of hotels and generally more ‘German metal’ on the road than my previous visits. Aside from these anecdotes, clearly regulatory and financial tightening has forced inefficient producers out of the steel market, with larger and more profitable operators who benefit from economies of scale still producing at near full capacity. Secondly, the government’s core objective of cleaning up the environment is forcing steel mills and other industrialised factories to reinvest in cleaner infrastructure to decrease pollution levels. What I found interesting was how local government officials, far from ignoring Beijing’s call for tighter environmental policy given the negative implications on growth, are implementing a stricter framework than Beijing is pushing for.
For example, we heard that the white smoke emissions from steel mills will not be allowed in Tangshan from November this year, despite the lack of producers with appropriate technology. While measures like this are likely to be watered down, it does highlight the seriousness of local authorities’ environmental conservation efforts. Clearly over tightening risks exist as the government’s focus shifts from quantity to quality of economic growth. However, we gain some comfort from the significant improvement in the coordination of policy and implementation over the last two years, and hence I think any signs of overtightening will be dealt with accordingly.
Steel producers and other market participants we spoke to weren’t overly concerned with the pick-up in protectionist rhetoric and policy from the US. The general sense was policies implemented so far were relatively modest in their effect, while any significant tightening would be self-defeating for the US. Admittedly I was a little surprised to see such a relaxed attitude, although we generally concur with the view, as detailed in a blog piece released last week. Moreover, discussions with a couple of reputable economists also highlighted risks from domestic overtightening far outweighed those of a trade war.
Soft economic activity data
The timing of the Chinese New Year (CNY) makes analysing and interpreting recent soft data prints extremely hard. Chinese demand data generally goes through a seasonal lag following CNY, but it seems to be uncharacteristically slow to recover this year. At this point and as a result of discussions from the trip, we believe that demand is delayed rather than permanently reduced. We are closely monitoring inventory levels of steel which appear to be moderating and hence provide some comfort that demand has merely been delayed rather than reduced. Weakness should therefore recover during the second quarter. Furthermore, consumer and business confidence surveys continue to point to a healthy macro-backdrop.
Despite slightly reducing some risk in our emerging market debt and emerging market multi-asset strategies before the recent sell-off, we are still positive on the global growth story. China’s contribution to the world economic expansion remains significant, and hence our constructive view on China supports our positive outlook on global growth. In our view, further sell-offs in asset prices relating to a Chinese growth slowdown will provide us with a good opportunity to increase risk at more attractive levels.
In terms of bottom-up positioning, we still hold a long position in the renminbi against other regional peers. The closing interest rate differential with the US (i.e. difference between US and Chinese interest rates) creates some challenges, but overall the balance of payments are in a robust position. Capital outflows remain contained, capital inflows are also gaining traction thanks to recent liberalisation measures and benchmark announcements, while strong global growth is continuing to underpin healthy export growth. Furthermore, we also think renminbi strength is welcomed by the authorities as it helps to contain capital outflow pressures while also assisting in trade negotiations with the US.
With the US Federal Reserve raising interest rates again on Wednesday, all short-dated US rates have been rising over the last 18 months, which accelerated somewhat after August 2017. However, markets have noted the particularly sharp rise in the rates of US dollar Libor unsecured funding, which has increased faster than other interest rates such as US Treasury Bills and swap rates.
The increase in Libor, its associated tightening in funding costs and the ripple into credit markets, shows that the US Federal Reserve’s (the Fed) two-year rate hiking programme is finally starting to have the desired tightening effect in specific financial markets. Asset markets are having to find their feet in this new environment and are a little bit more jumpy as they do that.
However, a positive side effect of this is that the Fed’s ultimate tightening destination may be closer than many feared and the Fed can remain gradual in getting there – a point supported by Fed Chairman Jerome Powell’s tone just last week. A regular theme of Federal Reserve communications has been a concern that without more balanced monetary policy, excessive risk taking may re-emerge in credit markets.
Several factors are driving the rises, including the impact of US tax reform which has seen US corporates bring back cash that they had previously been hoarding overseas. Money market reforms instituted following the global financial crisis have also limited the amount of US dollar funding European banks can access via US commercial-paper markets. Our base case is that end-quarter funding pressures are also at play, and these will ease once we enter April.
In general, we do not believe that rising Libor rates should have a strong direct economic impact. Unlike in 2007, the rise in this rate does not appear to represent a problem in bank funding in the US, but rather less availability of US dollars outside America. The vast majority of corporates which borrow in dollars have adjusted their funding to much longer-dated issues, and so will not be affected.
The rises can have an effect on corporate credit markets, where rising Libor rates can crowd out investment in investment-grade credit. So far this hasn’t happened. We are also closely watching Asian investment-grade credit markets, where many local investors use leverage to enhance yield. If Libor does not moderate in April (as in our base case), we may see selling in those markets. Currently, we are heavily underweight Asia in corporate debt funds and blended funds and a sell-off may create a buying opportunity for us.
In recent weeks, the US administration has acted on 2016 election promises to put America first in global trade policy. This has taken two forms – global metals tariffs, and China-specific tariffs relating to technology intellectual property theft. Our baseline is that this will not start a reciprocal trade war, and hence have limited medium-term impact on global growth and markets. A further sell off in risk assets may provide opportunities for investors to add risk. Our asset allocation preferences are emerging market currencies and equities.
Global metals tariffs were enacted under section 232 of the 1962 US Trade Expansion Act, citing the need to protect domestic steel production to ensure long-term self-sufficiency and hence national security. The US imported around 36 million tonnes of steel last year, and 6 million tonnes of aluminium, worth around US$40bn. Tariffs proposed were 25% and 10% respectively, representing a small fraction of the value of global trade in those metals. Additionally, the US has granted short-term exemptions to Canada, Mexico, the EU, Australia, South Korea, Argentina and Brazil, which account for about 75-80% of those imports. We expect deals to be reached exempting many kinds of specialist steels, as US industry ex-steel is lobbying hard against these measures. Thus this set of tariffs are not a major medium-term risk.
US Trade Representative Lighthizer has been investigating Chinese extraction of US intellectual property under section 301 of the 1977 US Trade Act. Independent estimates have put the long-term cost to the US economy in the range of US$200-400bn. Yesterday, President Trump announced tariffs averaging 25% on a list of goods worth up to $50bn in exports to the US. The final list of goods is yet to be announced, but will come within 15 days, with a 30-day consultation period. The net amount, US$12.5bn, would take around 0.1% off Chinese GDP.
China has responded with mixed rhetoric. A conciliatory speech earlier in the week from Premier Li acknowledging the need to reduce the barriers to foreign investment in China and to end technology transfer demands, reassured markets. This morning, China has announced tariffs of 10-25% on US$3bn worth of US agricultural imports in response to the original section 232 metals tariffs. The announcement carried a stronger tone, warning the US against further actions.
The current level of US tariffs, and the response from China, have both been smaller than we expected, given prior analysis. We do not see this as an incentive for China to escalate this trade conflict given the success of ongoing domestic economic reforms, while the US administration has achieved its PR goals. Our base case is therefore that this round of actions is now largely announced and reflected in markets.
In anticipation of this risk weighing on markets in the short term, earlier in the quarter we reduced emerging market currency exposure in our emerging market debt strategies, and equity risk in the emerging market multi asset strategy. However, in our base case of these trade actions remaining contained as outlined above, this will likely create opportunities to add risk to portfolios in those areas in coming weeks.
On a recent research trip to sub-Saharan Africa, we included a visit to Kenya to gain a better understanding of the country’s economic health after a disastrous 2017. Whilst there, we met with the central bank, IMF, Ministry of Finance, advisers and a domestic stock broker. Each helped form a unique insight into Kenya’s economy and we left feeling somewhat confident a recovery is finally beginning to take place.
2017 was a year to forget for Kenya. A combination of a mismanaged national election, drought, weak economic growth and a restrictive interest rate cap on debt were all factors weighing on the government’s debt balance, the current account deficit and economic growth.
Our trip, however, helped paint a different picture with cyclical factors laying the foundations for a mild economic recovery.
After a severe drought which saw food imports spike to 3x their historical average, the return of rain to the main food producing areas will help bring significant relief to the Kenyan economy. Agriculture accounts for almost 25% of GDP, and remains an important source of income for a large part of the population. The lower burden from food imports and some pick-up in agricultural exports will also help offset the impact of strong oil prices on the trade balance (Kenya is a net oil importer).
Despite the circus that was the Kenyan election, risks are now mostly in the rear-view mirror with Uhuru Kenyatta confirmed as president at the tail end of last year. Despite the opposition leader likely to continue making some noise, we expect to see a revival in business and consumer confidence. Increased political clarity will also help promote foreign direct investment which was severely lacking last year. The improvement in the political climate will not only assist in spurring investment, but should also support industries such as tourism. A recent announcement of direct flights starting from the United States signals increased foreign confidence in Kenyan political stability.
The implementation of a cap on the amount of interest being charged by banks (4% above the policy rate) has had a serious impact on Kenyans’ ability to obtain credit and only amplified the economic slowdown. However, our meeting with policymakers confirmed they are looking to amend the design of the cap, after lengthy discussions with banks to ensure that credit does start to flow once again. Over time, we expect its removal or amendment will help in restoring credit growth.
For some time now, we’ve seen a persistent unwillingness to address the fiscal deficit which is starting to put pressure on the relationship with multilateral donors like the IMF. Historically, Kenya has been entitled to almost US$1.5 billion in emergency credit. Our meeting with the IMF suggested the country would be unlikely to have this agreement renewed in its current form until the government starts to take serious measures aimed at tackling the fiscal deficit. We do, however, expect that the relationship with the IMF will continue, but the terms of the agreement will most likely change.
Despite the government’s ambitious capital expenditure programme being a positive for the long-term health of the economy, over the short term it places continued pressure on debt sustainability. It also implies the government is placing a one-sided bet on economic growth, which needs to start materialising over the next 3-5 years to ensure the debt rebalances to more sustainable levels.
Subsequent to our trip, Kenya came to the market with a 10- and 30-year euro-bond issuance. The market focused on the potential non-renewal of the IMF programme, and these securities were priced at a significant discount to similarly rated peers. We participated in the deal as this issuance offered exposure to an underappreciated and ignored story, while economic growth and the fiscal and current account are likely to improve materially this year.
We will continue to keep you updated on developments in the region and believe frontier opportunities like these add significant diversification benefits for our clients’ portfolios.
The last couple of weeks have been busy for China watchers – from the announcement of the removal of presidential term limits to Trump’s tariff announcements and the opening of the two-week National People’s Congress (NPC) at the weekend. Here are the key investment takeaways from the last week:
China GDP nowcast
Source: IAM, Haver, Bloomberg as at 28 February 2018. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: IAM, Haver, Bloomberg (as at 28 February 2018)
Trade war risks and a strategic opportunity for China
The ending of term limits poses concerns over the long term
I recently visited Delhi and Mumbai on a two day tour of India, meeting with a number of public sector officials, local private financial institutions, a political journalist and rating agencies. The timing of the trip was ideal, given the recent presentation of the Budget and the Reserve Bank of India’s (RBI) Monetary Policy Committee meeting.
These research trips are an invaluable part of our proprietary research and analysis, getting the view ‘on the ground’ which we wouldn’t necessarily have by staying at our desks. My trip to India was no different, and while there were lots of learning points, I highlight below the three key takeaways which I think are the most underappreciated by the market.
With legislative elections due around May 2019, these are now starting to appear on peoples’ radars. While there is a long way to go, the political analyst I spoke with expects the ruling Bharatiya Janata Party’s (BJP) to win the election, but lose its absolute majority by some distance. If this materialises, the BJP will become more reliant on their coalition partners which would likely throw more sand in the wheels of reform, disappointing those with the long held structurally positive view on India.
What was interesting is this loss of appeal appears more directed at the BJP than Prime Minister Modi, whose popularity remains very high. The government officials I spoke with appear very aware of this falling popularity and hence their number one priority for this year is growth. Upcoming local elections will be a good barometer of how much the Modi appeal and growth improvement sticks with voters. Relative to expectations, it feels the risks are skewed to the downside.
The local financial institutions I spoke with remain very reluctant to buy Indian government bonds, despite the sharp correction in yields over the last six months. While fundamental concerns are well flagged (higher oil prices, better growth, higher inflation etc), the recent RBI comments suggest they would not interfere in the bond market which effectively prompted a buyer’s strike. To offset this, the local financial institutions are hopeful that the central bank will increase the limit available for foreigner portfolio investors (FPIs) to invest in the bond market from the current 5% level. The RBI is due to announce the new limits towards the end of March/early April. The central bank previously supported increasing these limits providing the fiscal position was improving. However, fiscal consolidation has recently stagnated, and the budget announcement did not offer much comfort. Hence, there could be more disappointment in store for local financial institutions.
It remains well understood that Public Sector Banks (PSBs) in India have significant balance sheet issues which the government is trying to clean up by recapitalising them. Despite these government efforts, my discussions with rating agencies confirmed my previously held view that the magnitude of the recapitalisation is insufficient. This could delay the growth recovery beyond market expectations and add more pressure on the government’s finances through bigger capital injections.
Overall, there is growing uncertainty over the future path of the Indian macro story. There are important external factors to consider (oil prices, Fed policy etc) which can significantly impact the short term outlook for India, but the internal dynamics appear to be deteriorating relative to market expectations. Consequently, we retain our short positions in the currency and interest rate markets (in portfolios permitted to do so).
We recently completed a Zambian research trip, researching economic policy, politics, IMF programmes and debt sustainability. I had gone into the trip with a marginally positive view on fiscal progress made under the then Finance minister Felix Mutati, but unfortunately came away with serious concerns. The deterioration in local politics means that an IMF programme is unlikely as authorities remain reluctant to deal with the issues of external debt and public financial management that endanger debt sustainability. A cabinet reshuffle announced on the first day of our trip raised further alarm bells given the reform minded Finance Minister Mutati was effectively demoted to minister of supply and works. We now have little exposure to Zambian assets within our emerging market debt portfolios, believing the risk/reward opportunity is much more attractive in other parts of Africa and around the globe.
Since the economic crisis of 2015, the economy’s recovery has been painfully slow despite the tailwinds from higher copper prices, rising electricity and agricultural production. The partial revival in economic growth has done little to help correct bloated external debt levels.
The government had made some progress on fiscal reform, reducing subsidies and pushing a public financial management act which would require all contracted debt to have Ministry of Finance sign-off. Unfortunately scratching beneath the surface uncovered a different reality, with the government continuing to contract debts outside of the view of the ministry of finance. In light of President Lungu’s focus on securing support for a second term there may not be enough top down support to help correct this issue. An unexpected ministerial reshuffle over the last few days emphasises this point, as does the arrest of a key opposition leader last year (he was released, but charges remain on the book). Zambia does not enjoy the same freedom of the press as neighbouring South Africa.
After 18 months of back and forth with the IMF, authorities failed to secure an IMF programme at the final minute in September 2017 due to issues around debt transparency. Upon further investigation it became clear Chinese loans were granted at a ministerial level without Ministry of Finance sign-off. The government are still unable to provide guidance on the size, tenor and terms of these loans. Estimates from our trip put the Chinese debt number at almost 30% of GDP (US$6 billion), with disbursements over the next five years. This would mean that without any additional debt contraction Zambia would need to growth at least 6% annually to just keep the debt load stable, which is a situation we feel is unlikely and puts longer term debt sustainability into question.
While imbalances in the country have improved and remain manageable over the short term with the current account and fiscal deficits 3% and 6% respectively (as a % of GDP), risks are rising. Zambian authorities continue to bleed reserves due to high external interest payments and a lack of mining flows given the accumulation of VAT arrears. In our view, this scenario is not sustainable in the long-run and without any additional external funding or assistance from the IMF the country will become more vulnerable to an external shock. Zambia could avoid some of these funding shortfalls by issuing local currency debt, although in the current environment we believe the government will struggle to attract foreign inflows.
We have now cut our modest Zambian exposure to zero across all emerging market debt portfolios and will closely follow the current situation before we consider reengaging any long positions.
By raising South Africa’s VAT rate from 14% to 15%, the South African government indicated a willingness to take difficult (and unpopular) decisions in order to stabilise the fiscus. Coupled with the recent ousting of Zuma, this Budget should be enough to keep Moody’s on hold when they release their South Africa sovereign review on 22 March 2018. If a good cabinet is appointed in the coming week, it may even be enough for Moody’s also to move the outlook to stable from negative. However, there are two concerns – firstly, that the debt-to-GDP profile does not stabilise for five years, and secondly, the public sector wage settlement that is still being negotiated.
Overall, Finance Minister Malusi Gigaba presented a plausible, conservative budget with reasonable growth assumptions that focuses on what it is delivering this year rather than making promises of future consolidation. Revenue hikes totalling R36bn are planned for the 2018/2019 fiscal year, anchored by the VAT increase, which will add a projected R22.9bn, and the zero relief for inflation in the top four tax brackets, expected to bring in a further R6.8bn.
In terms of the growth forecasts, the National Treasury’s assumption of growth at 1.5% for 2018 is at the bottom of the consensus range, and there is definite room for upside if half the structural measures announced in President Ramaphosa’s State of the Nation Address materialise.
The main budget forecasts remain higher than we would have preferred, with the primary balance, which excludes interest payments, only moving to zero in the 2020/21 fiscal year. Nevertheless, the improvements are still substantial. The 2018/19 forecast falls from 4.5% to 3.8% of GDP, while the 2020/21 forecast declines from 4.6% to 3.7% of GDP. However, if growth of 3% materialises by late 2020, this alone would move the main budget deficit to 3.4% of GDP in that year.
The improvement in the debt profile, driven by the higher revenue forecasts due to the VAT hike and higher growth forecasts, is encouraging. However, with the debt-to-GDP ratio only peaking in the 2022/23 financial year, we need to see further progress at the Medium Term Budget Policy Statement in October this year.
Contrary to our expectations, there were virtually no cuts to overall expenditure over the medium term. Instead, there is a significant reprioritisation of spending in order to accommodate the R66bn needed in the next three years to fund free tertiary education. This leaves considerable room to cut spending if President Ramaphosa’s planned merger of government departments proceeds. However, the wage increases currently being negotiated with public servants is critical – any slippage from the budgeted wage bills will derail this budget.
Ultimately, all the budget woes would be resolved if we could get growth going. For example, if we could achieve a growth rate of 3% in SA the 2020/21 fiscal year, it would push up the primary main budget balance by 0.4 percentage points. Indeed, it should not be out of reach and the Budget Review sets out a breakdown of how GDP growth of 4% could be achieved. Assuming baseline GDP growth of 1.5% currently, the following factors could push it to 4%:
The Budget was always going to be a necessary, but not sufficient condition to shoring up South Africa’s one remaining investment grade credit rating and restoring the confidence of households, investors and businesses in the economy. This Budget is good. In light of the political flux it was produced within, it is excellent. It demonstrates the depth of the skills and commitment of the Treasury staff.
The key now is whether the widely expected cabinet reshuffle puts people in charge of key Ministries that produce a regulatory environment that pragmatically encourages investment while taking into account South Africa’s social context. As the Treasury noted, a boost to confidence alone will raise growth by 0.5%. Sectoral reforms will do much more.
Structural reforms are the key to improving South Africa’s growth outlook. However, it is far more helpful if this takes place in the context of a competitive currency. In 2017, emerging markets experienced inflows of US$100bn into dedicated equity and bond funds. While flows in 2018 have been more volatile, the expectation is that they continue. Therefore it is very clever of the National Treasury and Reserve Bank to loosen exchange controls for institutional funds. The Budget Review noted that offshore limit for institutional funds is increased by 5% for all categories, including the African allowance. Therefore the African allowance goes from 5% to 10% and the Rest of World category for institutional funds goes from 25% to 30%. Total ex-SA allowance is raised to 40%. This allows savers to continue to diversify their holdings, while likely providing some offset to the likely inflows as South Africa’s potential growth rate rises.
Chinese New Year is set to arrive on 16 February 2018, leaving behind the Year of the Rooster and ushering in the Year of the Dog. What are the key themes to look out for in the coming canine-related year?
Over the last few years, we’ve seen more sovereign downgrades than upgrades. This reflects rating agencies’ belated reaction to weaker growth, softer commodity prices and the deterioration in fiscal finances that occurred during the 2013-2015 period. Despite this, the credit fundamentals of EM sovereigns have arguably improved quite materially due to recovering economic growth, rising oil prices, greater fiscal consolidation and fading external vulnerabilities. The strong rise in EM capital markets from 2016 reflects this improvement, and we believe rating agencies will naturally start to respond by lifting aggregate ratings across emerging markets (EMs) in 2018 and beyond.
As Chart 1 demonstrates, the deterioration in EM credit ratings over the last few years has been a story almost entirely of oil. Net oil exporters experienced consistent downgrades as fiscal deficits and external imbalances ballooned on the back of the collapse in oil revenues. By contrast, oil importing EM countries saw little deterioration in credit quality over the last few years (Chart 2).
Chart 1: Cumulative credit rating momentum for net oil exporters vs Brent crude oil price
Source: Moody’s, Standard & Poor’s, Bloomberg, Investec Asset Management December 2017
Chart 2: Cumulative credit rating momentum for net oil importers
Source: Moody’s, Standard & Poor’s, Bloomberg, Investec Asset Management December 2017
With oil in a US$60-70 range, the fiscal outlook for oil exporting countries is expected to improve. The inherent backward-looking nature of credit rating agencies has yet to reflect this development. For instance, Fitch have seven net oil exporters on negative watch and only one on positive watch. The following themes support our view that 2018 EM credit dynamics should improve:
Chart 3: Debt-to-GDP levels of EM economies beginning to stabilise at healthy levels
Source: Investec Asset Management, IMF, JP Morgan December 2017
The recovery in credit dynamics will likely continue to help support EM dollar bond spread compression and act as a further tailwind for the entire EMD asset class through 2018. Of course exceptions exist for countries that fail to properly reform and rebalance their fiscal budgets, but they are in the minority and such dispersion creates a healthy alpha generating environment for us as active EMD investors.
For emerging markets (EMs), 2017 represented a year of disinflationary surprises. However, in recent months this trend has dissipated and if anything inflation began surprising more positively at the margin (see Figure 1). This supported our decision to stay fairly neutral on local currency bonds over the last few months.
Figure 1: Inflation surprises beginning to turn at the margins
Source: Haver, Bloomberg, Investec Asset Management December 2017
We think overall inflation will likely see less downside momentum, although analysing the investment universe on a country-by-country basis tells a much more interesting story. Even in countries where inflation is likely to pick up, the reasons for the inflationary momentum are largely idiosyncratic, ranging from a combination of base effects, pass-through from oil prices, to excessively loose monetary policy and a reduction in spare capacity in some economies. At the same time, in some markets we expect disinflationary momentum in 2018, and risks for the asset class remain fairly benign with very few EM economies close to overheating. Thus from a bottom-up perspective, diverging inflationary trends are providing a constructive alpha generating environment.
The rise in oil prices has led to some pass-through inflation in a number of net oil-importing countries. For example, Indian fuel inflation hit nearly 8% in November, the highest since 2013. Similarly, food inflation rose significantly, and core inflation has also started ticking modestly higher. This will likely force the Reserve Bank of India to commence an interest rate hiking cycle in the first few months of 2018, and therefore we prefer to play from the short side.
The pick-up in inflation also reflects the cyclical bounce beginning to reduce slack in some EM economies. In recent years, tight labour conditions failed to generate inflation in the Central and Eastern European (CEE) region, but this may finally be beginning to change. Czech growth may have only pushed up core inflation towards 2%, but this represents a multi-year high, and has encouraged the Czech National Bank to start its hiking cycle. This keeps us generally bearish on local bonds and rates, while we are more positive in FX. Hungary also experienced a surge in core inflation this year, although headline inflation will likely remain below target for 2018, and given the central bank’s commitment to flattening the yield curve we continue to like longer-maturing local bonds.
In contrast to the Czech Republic, the Romanian central bank has been somewhat behind the curve, as our basic Taylor rule suggests (Figure 2), with inflation rising above target for the first time in four years. To date, the central bank’s attempts to control inflation by narrowing the interest rate corridor seem inadequate, with headline inflation surprising higher to 3.2% in November. This should finally encourage the central bank to raise interest rates in early 2018.
Figure 2: Romania Taylor rule suggests the central bank is behind the curve
Source: Haver, Bloomberg, Investec Asset Management December 2017 Taylor rule – This rule is an approximation tool used to estimate the responsiveness of nominal interest rates to changes in inflation, output, or other economic conditions
The lack of central bank credibility in Turkey has allowed core inflation (12%) and inflation expectations (9.3%) to hit 13-year highs. December’s rate tightening underwhelmed market expectations, and it’s likely that the FX pass-through from the weak lira will force the central bank into aggressively hiking rates in the early months of 2018.
Two markets in particular – Brazil and Russia – epitomised the disinflationary momentum over the last 18 months. Nevertheless central banks in both countries showed unprecedented restraint by only gradually lowering interest rates, therefore helping anchor inflationary expectations. This succeeded in both countries, with inflation rates moving from double digits in 2016 to below 3% now, and below or within their central bank’s targets. Naturally this trend is now beginning to slow and we should see a modest pick-up in inflation through the first half of 2018 (Figure 3).
We don’t find Brazilian local bonds particularly appealing at these levels. While we’ve been positive on Russia for most of 2017 we’re more bearish now, despite the central bank surprising markets with a dovish cut in December. We currently feel less optimistic for future interest rate cuts, with base effects creeping into inflation numbers and valuations looking somewhat stretched. Given the cyclical pick-up in economic growth and external account dynamics in both markets, we are more constructive on currencies than bonds for now.
Brazil headline CPI - dynamic PCA %yoy
Source: Haver, Bloomberg, Investec Asset Management calculations December 2017
There are other markets, particularly in Latin America, where we still see material room for inflation to fall through the coming months. Argentina remains the most extreme example, with inflation still close to 25% and the central bank keeping rates very high to try and push down inflation expectations. While we think they will eventually manage to succeed in doing this, it will inevitably take time. Given the extent of the yield curve inversion, the risk reward pay-off is much more attractive in T-bills where we can still pick up a yield of close to 30%.
Chart 4: Argentine inflation nowcast points to disinflation through first half of 2018
Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results.
Source: Haver, Bloomberg, Investec Asset Management calculations December 2017 Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
In Mexico, Banxico retained its hawkish bias, delivering a cumulative 150 basis point hike this year in a bid to suppress inflation expectations. Our nowcast points to a tick down in inflation during the first half of this year and while longer-dated bonds may come under pressure from political news, we maintain a constructive view on the mid-part of the curve. We also remain constructive on Peruvian local bonds, due partly to our views on inflation. Lacklustre growth is having some downward pressure on pricing pressures, allowing the central bank to lower interest rates. Outside of Latin America, South Africa represents another market which should experience some disinflationary momentum this year, which we expect the central bank to recognise by cutting rates during the first quarter of this year. This, combined with the market pleasing ANC election outcome, keeps us positive on the country’s bonds going into 2018.
As we have mentioned before, emerging markets (EMs) are at the start of a busy election calendar over the next 12-18 months. Election outcomes can be crucial in driving policy direction and therefore asset prices. This past weekend we had the first three of these EM elections, and all resulted in the more market friendly outcome. In the case of South Africa, this wasn’t straightforward but Ramaphosa’s victory represents a transformational moment for this young democracy and its people.
Let’s start with the least market-moving election, the local elections in two Indian states, Gujarat and Himachal Pradesh. While of limited economic impact, the elections were an important litmus test of Prime Minister Modi’s popularity and reform agenda, particularly important given the next general election is less than 18 months away. It was an encouraging victory for this party, which secured majorities in both states. Admittedly the size of the majority in Gujarat was a bit disappointing, although the BJP recorded a better than expected result in Himachal Pradesh. Overall we see the result as a positive one for the BJP, with the current trajectory of reforms likely to stay in place.
Meanwhile in Chile, pro-business ex-President Sebastien Pinera was elected after the second round of the Presidential Election. After a tighter than expected first round (which spooked the markets), Pinera easily defeated the leftist Guillier, with a projected 55% share of the vote. During four years of Bachelet, the reform agenda stalled and more populist policies were adopted. Thus the business-friendly Pinera should ensure a more pro-reform agenda in the coming years. This resulted in the Chilean peso being one of the strongest EM currencies this month, up 4.5% (at the time of writing). We remain constructive on Chile and believe we can see positive reforms, improved business sentiment and a pick-up in growth after a few disappointing years.
The most hotly contested and arguably most important election this weekend was not a public one, but the internal election for the ANC Presidency. The election polarised the ANC and indeed the country with Nkosazana Dlamini Zuma (NDZ) representing the under-fire Zuma faction, which is accused of blatant corruption and weak economic and fiscal policies, versus the more market-friendly candidate Cyril Ramaphosa. The policy differences between the two candidates meant the market viewed the outcome as binary, with a Ramaphosa win representing a return to the days of prudent macro policy and a NDZ victory symbolising a continuation of institutional decline.
As the market gained greater confidence of Ramaphosa’s victory, the rand rallied (by over 6% this month at the time of writing). Ultimately, internal divisions meant that a compromise result was inevitable. As such, despite Mr Ramaphosa taking the ANC presidency (and likely South Africa’s presidency in the next national election) the top-6 party positions were split 3-3 across the factions, with at least two deeply compromised people (David Mabuza and Ace Magashule) taking senior positions. This highlights the need for caution, and clearly we also need to see how quickly Ramaphosa’s victory translates into better policy as he balances the demands of both the nation and the ANC itself. But overall, this result is a positive for South Africa’s future.
All in all, these three results were encouraging. This may well set the scene for further positive outcomes in the busy 2018 election cycle. This combined with a strong economic growth outlook and relatively attractive valuations, should bode well for Emerging Market Debt returns in the New Year.
Figures below showing: Argentine growth looks set to remain solid, aiding the fiscal adjustment but keeping the current account deficit wide and inflation reasonably high
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Figures below showing: That despite the short-term political risk, external balances in Chile are improving as shown in the nowcast, while inflation risks remain reasonably contained
Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017 Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017
Source: Haver, Bloomberg, Banco Central de Chile, IAM calculations November 2017
1Peronism – is a brand of populist and nationalistic politics that has a history dating back to the mid-1940s in Argentina.
2As at November 2017.
3PPPs often involve a contract between a public sector authority and a private party.
While rising African debt levels occupy headlines1, we sift fact from fiction below, and discuss how we evaluate opportunities. Read more by downloading the full Viewpoint here.
Debt dynamics across the region, defined here as median gross government debt to GDP, have gone through three main cycles over the past 20 years:
Following a sharp rise in indebtedness in the 1990s, the early part of the 2000’s was a period of debt consolidation and write-offs in Africa as a result of the Heavily Indebted Poor Countries (HIPC)2 programme and its replacement, the Multilateral Debt Relief Initiative (MDRI)3.
After a sustained period of consolidation, with median debt to GDP hitting a low of 38.1% in 2008, the exponential rise in commodity prices helped stimulate growth and investment into Africa. African governments borrowed in international markets to support investment expenditure – but as deficits worsened, risk rose.
As oil prices collapsed from June 2014, accompanied by rising borrowing costs, balance sheets deteriorated. However, re-leveraging across Africa and other frontier markets (Chart 1 below) hasn’t been at the expense of debt balances, given growth.
Chart 1 – Regional Emerging Market Gross Government Debt as a % of GDP
Source: IMF WEO, IAM Calculations October 2017
The African region is expected to deleverage from now until 2022, reflecting stabilisation in commodity prices, improvement in global growth and economic reforms that were implemented during the crisis.
While the build-up of African debt balances is a risk, balance sheets should stabilise below distressed levels, providing the external environment remains stable.
With 54 countries across the region, we recognise that Africa represents a diverse investment universe; real value can be added by understanding divergences within Africa, and acting on these insights through active country allocations. So how do we differentiate?
Looking across the African continent we can split our economies into four broad categories.
The dispersion of economic fortunes across Africa represents opportunity for the discriminating. We continue to favour reforming countries and reflect this in the portfolio through positions in Egypt, Nigeria, Morocco and Zambia, where permitted. We also selectively allocate to countries such as the Ivory Coast and Uganda given their manageable debt metrics and attractive growth rates. Looking beyond the negative headlines, the period ahead still looks promising and we will continue to keep you updated on interesting trends across the continent.
1 Most prominently through the Financial Times’ article titled ‘African debt worries intensify as levels near tipping point’ (click here).
2 Is a group of 39 developing countries (33 of which are in Africa) which qualify for debt relief and low interest rate loans from the IMF and World Bank, where debts are considered unsustainable (defined as debt to exports>200-250% or when debt to government revenues exceeded 280%). Initially launched in 1996 it has provided full or partial debt relief to 36 countries.
A silver lining of the Trump administration’s protectionist agenda has been that emerging market (EM) governments have, on the whole, reaffirmed their commitment to freer trade. Reassuringly, they recognise the positive influence of open markets in driving EM economic growth over the last three decades.
While Trump stole much of the headlines from the APEC meeting over the weekend, 11 countries (including Malaysia, Chile and Peru) finally agreed to push ahead with a revised version of the Trans Pacific Partnership (TPP)*. This strongly signalled remaining participants’ commitment to trade liberalisation, despite Trump withdrawing from the agreement during his first day in office. Even without US involvement, the scale of the prospective agreement is significant – 500 million people and over US$10 trillion in aggregate GDP. That said, without US involvement, the economic gains are more modest. A recent paper from the Peterson Institute for International Economics (PIIE) highlighted the economic benefits of TPP (ex-US) would be limited to approximately US$150 billion, or less than half the benefits of the agreement with US participation. However, if the five other Asian countries that have shown an interest in the agreement were to join then the economic benefits would approach those of the original TPP according to the PIEE analysis.
Also at the weekend was a modestly disappointing delay to the other large putative Asia-centric trade agreement, the Regional Comprehensive Economic Partnership (RCEP)**. A ministerial meeting at the side-lines of the Asean summit in Manilla decided to push back the timeline till 2018 (there had been hopes it could be signed this year).
A trade deal does, however, still seem very likely. RCEP is regarded as a lower quality trade agreement than TPP (limited coverage of services & investment, and weaker labour and environmental provisions), however it covers a much larger GDP base (4 of 10 largest global economies are in RCEP). PIIE estimate global income gains of around US$300 billion and the economic benefits could be significantly higher if countries like Japan and Australia manage to succeed in getting some services provisions into the agreement. Moreover, both agreements can facilitate a framework for further rounds of gradual trade liberalisation (possibly with US involvement under a more receptive administration).
Admittedly both trade agreements have a long way to go, although the progress to date shows that the world is moving ahead with trade liberalisation despite the US flirting with protectionism. This should help to underpin global trade growth over time. As Chart 1 shows, the rate of trade expansion has been lacklustre since the financial crisis – partly reflecting cyclical factors like the sluggish pace of global economic growth, but also structural factors such as the shortening of global supply chains (particularly in China).
The stalling of the Doha round of global trade negotiations and lack of progress on regional trade agreements has also likely played a significant role in the trade slowdown. Indeed, just a year ago, considerable gloom existed among trade economists. Now, fresh progress on trade agreements, driven in part by emerging markets, could help to underpin a longer-term re-acceleration in trade growth (which has already started to pick-up somewhat with the cyclical upswing in global economic activity). Thus, while there are significant concerns around the future of Nafta and Korea-US Free trade agreement, clearly the US administration is not going to be able to reverse the long-run trend towards greater trade liberalisation, and that EM governments recognise the importance of open trade for their economies.
Chart 1: Global trade volume growth (year-on-year %)
Source: Investec Asset Management, CPB Trade Monitor, November 2017
*TPP members: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam.
**RCEP members: 10 ASEAN countries + Australia, China, India, Japan, South Korea and New Zealand.
What we know:
Impact on bonds:
Our strategy from here:
The nineteenth National Congress of the Chinese Communist Party (the Party) was held from 18 - 24 October, followed by the First Plenary session today (25 October). As expected, President Xi cemented his status as the “Core Leader” of the Party; with “Xi Jinping Thought” having been enshrined into the Constitution. Furthermore, no obvious successor exists within the newly formed Politburo Standing Committee, increasing Xi’s chances of serving past his expected retirement in 2022. Consequently, the significance of other personnel changes was diluted, but from our perspective there will be little to distract President Xi from his policy agenda for the remainder of his term.
At the beginning of the National Congress, Xi’s Work Report laid out the broad plans for the next 30 years. Nevertheless, the market will focus most heavily on what to expect over the next 12 months. In terms of policy direction and momentum, we don’t expect much of a change over the short-to-medium term.
Firstly, Xi has long been considered the most powerful president for decades, so the last week has essentially rubber stamped a process which has been evolving over the last five years and was already well understood. Secondly, and somewhat related, we have seen an impressive shift in the gears of policy implementation over the last 18 months, with a clear focus on better supply side management. This contrasted with previous years where too much emphasis was placed on boosting demand through aggressive credit growth. As a result, the need for drastic policy change is limited at this stage. We therefore expect a continued focus on deleveraging, reducing excess capacity and pollution through SOE shutdowns and tightening controls on the property market to contain overheating risks.
From a portfolio perspective, we remain constructive on the Chinese renminbi. The balance of payments is in surplus as capital outflow pressures have eased significantly. Nevertheless, we still see some evidence of disguised capital outflows and hence do not expect any imminent capital account liberalisation. Trump’s visit to China next month comes as the trade balance between the two countries continues to widen, therefore ongoing currency stability or mild strength will be in China’s best interests.
It’s been a fantastic run for local currency emerging market debt (EMD) this year – up around 15% (in US dollars)1 and on track for its best return since 2009. Despite the strong rally, we believe that at a time of stretched valuations across other capital markets, local currency EMD is one of the few global asset classes offering genuine value. Both elements of local currency bond returns – yield and FX – appear to have room to appreciate further from current levels, particularly in high yielding markets.
If we turn to yields first, the GBI-EM weighted index yield is hovering around 6% at present. This remains relatively high compared to history, but on a real (inflation adjusted) basis valuations look even more attractive. The below table highlights the scale of disinflation across some of our key markets.
|Current consumer price index (CPI)2||10 year CPI average|
Source: Bloomberg, 30 September 2017
Pleasingly, monetary authorities have shown unprecedented discipline when reducing interest rates – a function of the increasing independence of EM central banks and their adoption of explicit inflation-targeting regimes (in countries as diverse as Argentina and Ukraine). While some central banks began easing monetary policy to support their economies – particularly in recession-hit countries like Russia and Brazil – they have done so in a largely credible fashion, ensuring inflation expectations remain anchored.
Consequently, interest rate reductions have generally been quite modest which has helped keep real interest rates and local bond yields high versus history. This relationship appears particularly noticeable when we compare the real yield between high and low yielding EM bond markets, as can be seen in Chart 1. In the high yield space, real yields remain close to their highs. With structurally lower inflation being sustained by credible central bank policy, nominal yields should continue falling outside of any external shock. By contrast, low yielding bond valuations look closer to fair value, although they don’t look exorbitantly expensive relative to history.
Chart 1: GBI-EM real bond yields across high and low yielding markets
Source: Haver, Bloomberg and IAM September 2017
Chart 2: EM real yield differential over developed markets remains elevated, and above its historic average
Source: Source: Haver, Bloomberg and IAM September 2017
This real yield buffer should continue to support foreign inflows, especially considering the attractiveness of EM currency valuations. On a nominal effective exchange rate basis 3, EMFX performance this year has been lacklustre given the strength of the euro. Similarly, using the real effective exchange rate (REER) method4, EMFX also looks inexpensive compared to history, particularly high yielding EMFX5. Even after accounting for the changed macro environment, we believe EM REERs for a number of high yield currencies remain 5-10% below fair value.
Chart 3: ELMI weighted REER high yield vs low yielding currencies
Source: Haver, Bloomberg, JPMorgan and IAM September 2017
The robust growth outlook across emerging markets should support further REER appreciation over the next few months, as we are still at a relatively early stage in this cyclical pick-up. As well as positive bond flows, equity flows should also be supportive given positioning remains light (indeed there has been net selling in recent months) and the fundamentals are improving, with net income margins rising, and as Chart 4 highlights, forward price-to-earnings (P/E) ratios6 still attractive relative to history and developed markets.
Chart 4: Developed vs emerging market equity valuations using P/E ratios
Source: Haver, Bloomberg and IAM September 2017
Thus we see fundamentals, valuations and positioning all still lining up positively to support local currency EMD over the medium term. With several emerging market economies also set to benefit from an increased stock of capital, technological progress and pro-market structural reforms this allocation argument is only strengthened.
1 As at 30 September 2017
2 Year-on-year change in the index
3 The weighted average rate at which one country’s currency exchanges for a basket of other currencies, not adjusted for inflation
4 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation
5 FX valuations need to be framed within the context of the end of the commodities super cycle, which drove the structural break in EM growth to a more sustainable, but lower rate, as well as driving the deterioration in in commodity terms of trade
6 The forward price-to-earnings ratio is a company’s current stock price divided by its estimated earnings per share
Falling oil prices, an import-dependent economy and multiple policy mistakes by authorities almost tipped Nigeria into depression. Over the last two years we have had little-to-no exposure to Nigeria on the back of our pessimistic view of Nigerian economic policymaking in an environment of lower oil prices. This strategy has not only saved our clients from significant losses, but also ensured that our EMD strategies faced no repatriation risks due to significant shortages of US dollars. However, in our view, an opportunity is beginning to open up and we are re-allocating to a country with improving economic fundamentals, more sensible economic policy settings and one which is priced attractively.
The casual observer could be forgiven for thinking a real election just took place in Argentina. It was, however, just a primary – the elections only take place on 22nd October. But primaries in Argentina are quite unique – all parties take part in the same vote. Thus it provides an important gauge of the political climate in the country – the first true indication since Macri’s election victory in 2015. And the results were a positive surprise for him and investors. Give market weakness over the last few weeks, the result precipitated a strong rally in Argentine assets with the peso rallying 3% on the news and dollar spreads closing 40bps tighter as the market.
Accessing China’s interbank bond market is set to become significantly easier following the implementation of China Hong Kong Bond Connect (CHKBC) in July 2017. CHKBC forms a direct, efficient and transparent platform for offshore institutional investors to access the mainland’s debt market, and will almost certainly be the preferred bond market route for new investors. In our view, CHKBC will inevitably speed up the timing of China’s index inclusion and enable a constant flow of capital from international investors. The Chinese bond market remains a compelling investment opportunity given its yield and diversification benefits, and with operational barriers being broken down further this argument is only strengthened.
Our core EMD funds already have the flexibility to trade in China through either RQFII or CIBM direct. However, given the increased flexibility of CHKBC we can use this method for any future funds or segregated portfolios which have not yet had access to the Chinese bond market.