Navigation Search
Close

Select your location and role to view strategy and fund content

Australia
  • Global homepage
  • Australia
  • Belgique
  • Botswana
  • Denmark
  • Deutschland
  • España
  • Finland (Suomi)
  • France
  • Hong Kong (香港)
  • Ireland
  • Italia
  • Luxembourg
  • Namibia
  • Nederland
  • Norway
  • Österreich
  • Singapore
  • South Africa
  • Sweden (Sverige)
  • Switzerland
  • United Kingdom
  • United States
  • International
Professional Investor
  • Professional Investor

This website is for Wholesale Clients (as defined in the Corporations Act and applicable regulations) only and provides information on our products, strategies and services. Please remember capital is at risk and past performance is not a guide to the future.

By entering you agree to our Terms & Conditions

Emerging Perspectives

Our expert team examines the dynamic world of emerging market debt

Views on frontier markets from the IMF spring meetings

Thys Louw, Assistant Portfolio Manager

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

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.

  • What to watch out for – GDP rebasing which could see 20% revision in GDP making debt to GDP look more benign, ; Ability to raise non-tax revenues

Egypt

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.

  • What to watch out for – Micro-reforms to help kick-start the private investment cycle; Risks of social unrest in case youth unemployment is not addressed

Nigeria

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.

  • What to watch out for – General elections in February 2019; Unrest in the Niger delta hurting oil production

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

Argentina

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.

  • What to watch out for – Central bank stance on inflation and exchange rate; Progress on wage negotiations with unions

Costa Rica

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.

  • What to watch out for – Constitutional Court and new congress stance on proposed fiscal reform package; Progress on wage negotiations with unions

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

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.

  • What to watch out for – Willingness of government to address outstanding IMF issues (Anti-corruption court, gas price hikes); Plan post expiry of program in March 2019

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.

Pakistan

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.

  • What to watch out for – Stance from new government post general election in July 2018, Changes to currency policy as pre-cursor to engagement with IMF

Zambia

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

  • What to watch out for – Debt sustainability analysis to be released from Zambian authorities; New IMF Article IV on Zambia; Foreign Exchange Reserve levels

Election fever strikes Latin America

Vivienne Taberer, Portfolio Manager

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.

Summary

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.


China: shifting focus from financial to environmental health

Mark Evans, Analyst

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.

Tariff anxiety?

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.

Portfolio positioning

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.


 

Libor rate rise and its impact on Emerging Market Debt

Mike Hugman, Portfolio manager

Mike Hugman, Emerging Markets Fixed Income Portfolio Manager, argues that outside corporate credit markets, the sharp rise in Libor should not have a deep economic impact.


Libor on the rise

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.

A multitude of drivers

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.

Little direct economic impact …

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.

… except for corporate credit markets

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.


 

US Tariffs and their effects on Emerging Market Debt

Mike Hugman, Portfolio manager

Mike Hugman, Emerging Markets Fixed Income Portfolio Manager, argues that this round of actions is now largely announced and reflected in markets and will create opportunities to add risk to portfolios via EM currencies and equities in coming weeks.


Opportunities amid volatility

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.

Metals tariffs not a major medium-term risk

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.

The case of China

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.

Our base case: largely in the price

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.


Kenya: A difficult 2017 but a more favourable picture is emerging

By Thys Louw, Assistant Portfolio Manager, Emerging Market Fixed Income, Investec Asset Management

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.

Coming out the other side…

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.

  1. The drought

    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).

  2. Politics

    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.

  3. The interest rate cap

    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.

 

A cyclical bounce in growth likely, but risks remain

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.

The unloved investment opportunity

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.


Tariffs, targets and term limits – where to from here for China?

Roger Mark, Product Specialist and Wilfred Wee, Portfolio Manager

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:

  • Short-term macro stability remains key, but we have greater confidence that we will see a renewed emphasis on structural reforms.
  • Beijing will likely tread carefully on trade; there are real risks of a global trade war, but there is a strategic opportunity to reposition China at the forefront of the global trading system.
  • Political changes should enhance the decision-making progress over the near term, but raise long-term concerns about the future governance of the country.

Short-term macro stability, with a renewed emphasis on structural reforms over the medium term

  • As part of the opening of the two-week session of the NPC, Premier Li Keqiang announced the targets for the year. The key numbers were generally as expected.
    • The growth target was kept at 6.5%, but the removal of the phrase “higher if possible in practice”, suggests greater realism in respect of China’s potential growth. Our nowcast in Chart 1 points to near-term stability around that target, albeit with modest downside risk as a natural result of some of the financial regulatory tightening and industrial capacity cuts. However, Chart 2 shows potential growth continues its moderating trajectory.
    • From a monetary perspective, the inflation target was kept at 3% and quantitative targets for bank lending, total social financing and M2 growth were removed for the first time since 2009, suggesting that resource allocation around monetary policy is graduating from a quantitatively-anchored system to a much more price-based one. Instead, they will be maintained at an “appropriate” level of growth.
    • The formal budget deficit target was lowered to 2.6% from 3% the year before – a signal of the macro tightening bias as the economy moves away from the downside risk in the 2012-2016 period.
    • Finally, the introduction of an unemployment target – linked to both registered and unregistered workers – perhaps reflects the growing importance of employment in ensuring the regime’s legitimacy as China moves away from the transformative high growth era.
  • If the targets pointed to continued focus on short-term stability, there were also announcements relating to more structural changes: further easing of foreign ownership limits in financial services and expansion of foreign access into other sectors such as telecommunications. Moreover, the government also reiterated its commitment to supply-side reforms.
  • Indeed, with this being the first NPC since the 18th Party Congress, the coming days will be carefully watched for new appointments and further details on the structural reform agenda.
  • Economic policy is likely to be placed under the overall responsibility of Liu He – a key ally of President Xi Jinping. He is set to be named vice premier for the economy and financial sector (and according to some reports possibly the next governor of the People’s Bank of China). If the local press is anything to go by, he will head up a highly experienced economics team drawn from senior roles across the country’s financial system.
  • This bodes well for the reform agenda, and while investors have been disappointed with the scope of reforms since the overpromises of the 2013 third plenum of the 18th Party Congress[1], there are reasons for thinking the reform agenda may finally start to accelerate:
    • The focus in recent years was on ensuring stability – first in reaction to macro weaknesses and then in the run-up to the 19th Party Congress. Policy-making can become more ambitious now.
    • Xi has consolidated power significantly – his allies dominate the Politburo and the Central Committee’s Leading Small Groups.
    • This concentration of power together with the trust Xi’s economics team has earned in the run up to the 18th Party Congress, bodes well for more far-reaching decisions in the months ahead.
  • Overall, the policy direction seems to be as it’s been for a number of years: short-term stability, medium-term reform. But this time the reform agenda may actually exceed investor expectations as Liu promised at Davos. We expect greater focus on private sector investment, aimed at innovation and upgrading. This will be a big challenge, but it would be a huge multi-year growth driver.
  • In addition, it looks like there will be further focus on the delivery of improved social (inequality, housing) and environmental governance.
Chart 1: 

China GDP nowcast


Econometric modelling is inherently imperfect and not a reliable indicator of future results. 

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.

Chart 2: China finance neutral trend GDP growth vs. actual

Source: IAM, Haver, Bloomberg (as at 28 February 2018)

Trade war risks and a strategic opportunity for China

  • Trump’s tariff announcement coincided with Liu He’s visit to the White House to discuss trade.
  • The steel and aluminium tariffs that Trump announced were ostensibly aimed at China given the national security pretext, despite the impact being much greater on America’s allies and neighbours.
  • Aluminium and steel make up a negligible part of the bilateral trade deficit. This helps to explain the tempered response so far from Beijing. It also arguably reflects China’s self interest in ensuring calm in the global trading system. Trump’s trade policies present a strategic opportunity for China to strengthen trade relationships and links with countries that have traditionally been within the US sphere of influence.
  • However, the Trump administration is unlikely to be finished with its protectionist trade agenda and significant targeted action against China is very likely in the future. The fact that Trump refused to meet Liu He last week speaks volumes – this was a snub aimed at President Xi. The key development we will be monitoring is the recommendations from the US Trade Representative’s investigation under Section 301 of the 1974 Trade Act into intellectual property and technology transfer. On the back of the findings, President Trump has wide discretion to impose significant protectionist measures. It’s hard to make a call on White House policy at the moment, but it is likely some sort of action under section 301 will happen in the coming months. Trump has until August to make an announcement.

The ending of term limits poses concerns over the long term

  • The abolition of term limits of the presidency is simply the latest victory for Xi in his consolidation of power.
  • If Xi stays on as president it is highly likely that he will stay on as General Secretary of the Communist Party beyond the current age limit. (This is where de facto power lies since the end of the Deng era.)
  • The message is thus clear: the era of term limits and age limits are coming to an end. These have served as an effective check on the leadership of the Chinese Communist Party (CCP) since the Deng era to prevent another Mao or stagnation into Soviet-style gerontocracy. The CCP will have to find new norms, or risk the dangers inherent in despotism. The lessons from history are hardly encouraging. Thus while we are encouraged about the shorter-term impact of more effective decision-making on macro-economic reform, the removal of term limits is a negative for the country’s long-term development path.


Views from the road: India

Mark Evans, Analyst

Mark Evans discusses his recent trip to India and his concerns over the politics, inflation and the capital adequacy of some of the public sector banks.

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.

BJP’s ground a little shakier

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.

Indian Government Bonds – who’s going to buy them?

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.

Public Sector Banks in dire need of capital boost

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.

Portfolio positioning

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).


Views from the road: Zambia

Thys Louw, Assistant portfolio manager

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.

Short term political gains a higher priority than necessary reforms

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.

Scandals delays IMF deal

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.

The financial cliff is approaching at a steady pace

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.

Portfolio positioning

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.


Ramaphosa’s South Africa delivers market pleasing budget

Nazmeera Moola, Co-head of Africa and South Africa Fixed Income

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%:

  • Improved confidence: +0.5%
  • Telecoms reforms: +0.6%
  • Lower barriers to entry for small business: +0.6%
  • Transport reforms: +0.3%
  • Promotion of agriculture & tourism: +0.2%

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.


Five investment themes for the ‘Year of the Dog’

By Greg Kuhnert, Wilfred Wee & Michael Power

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?


Improving emerging market credit dynamics yet to be reflected in ratings

Roger Mark, Product specialist

Improving emerging market credit dynamics yet to be reflected in ratings

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:

  • Fiscal balances on the whole are recovering. This reflects both spending discipline, but also greater revenue generation. Meanwhile, net oil importers have made some progress in abolishing or reducing unsustainable fuel subsidies.
  • In many markets, governments are taking steps to strengthen institutions, investing in social capital and making their economies more competitive. This should help sustain the recent increase in trend growth.
  • Taken together, expanding economies and fiscal consolidation should stabilise debt-to-GDP ratios at low levels (chart 3). Despite net oil exporters increasing debt levels during 2014-2016, they should also experience some debt stabilisation at very healthy levels (especially if we compare to G7 debt-to-GDP levels of over 100%).
  • Lastly, external vulnerabilities have become much less pronounced, with current account deficits narrowing, foreign direct investment flows accelerating and FX reserves rebuilding to sustainable levels.

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.

 


Diverging inflationary trends: Helping unlock alpha opportunities

Peter Eerdmans, Co-Head of Emerging Market Fixed Income

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

GBI yield vs GBI inflation surprises

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.

Inflationary momentum turns modestly positive from cyclical lows

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.

Inflationary pressure being met by a slow central bank response

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

Romania Finance-neutral Taylor rule: growth gap

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.

Ebbing disinflationary momentum

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

Figure 3: Brazilian inflation nowcast

Source: Haver, Bloomberg, Investec Asset Management calculations December 2017

Markets where inflation can fall further in 2018

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

Argentina San Luis CPI - dynamic PCA %yoy

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.

 


Emerging market elections; market-pleasing results in three countries

Peter Eerdmans, Co-Head of Emerging Market Fixed Income

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.

Modi passes local election test

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.

Pinera returns to the helm in Chile

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.

Ramaphosa’s victory brings new hope for South Africa

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.

 


Once unthinkable policy progress being made across the Southern Cone

Mike Hugman, Portfolio Manager

I just spent a week in the Southern Cone in Latin America, meeting with policy makers, political analysts, think tanks, NGOs and local investors. Key observations on politics, macro, ESG and investment conclusions are given below.

ARGENTINA:

Politics:

  • Despite only winning 40% of the vote in the recent mid-term elections and lacking a majority in the lower House of Congress, President Macri and his Cambiemos coalition have strong momentum. Furthermore, they are making rapid progress in passing reforms (capital markets, labour, pensions) as moderate Peronists1 we met with on the trip clearly have a strong incentive to co-operate. No-one wants to be closely associated with former President Cristina Kirchner’s radical Peronists right now.
  • The rapid signing of a fiscal pact that lowers provinces’ deficits reflects this degree of cooperation, including those still run by radical Peronists (i.e. the hard left). This paves the way for pension reform and further long-term controls on government spending. Meetings with Provincial Finance secretaries were encouraging in terms of the coherence of their fiscal adjustment programmes in the national context.
  • While the resurgence of the centrist political parties in Argentine politics remains fragile for now, the electoral institutions are designed to support this trend. Most importantly, whilst President Macri is now the favourite for 2019 Presidential elections, his coalition includes a number of impressive potential successors from the next generation. This includes the Governor of the Province of Buenos Aires Maria Eugenia Vidal. Encouragingly, several political analysts who we met with believed that a sustainable rebalancing of Argentine politics is likely.

Macro fundamentals:

  • Argentina’s macro adjustment remains challenging given its heavy reliance on external borrowing over the next 2-3 years to sustain the fiscal deficit. In our meetings with the Economy Ministry, Finance Secretary and Central Bank this was clearly acknowledged as the major challenge for 2018/19.
  • However, fiscal performance for 2017 appears set to exceed expectations of -4.2% of GDP deficit, making next year’s -3.2% target much easier to reach. Most importantly, with bank credit/GDP at 14% after a decade of financial autarky (Sudan is 22%, DRC 13%), financial deepening (i.e. increased credit availability) provides an engine for growth which can facilitate this period of rebalancing. Banks we met see loan growth of 50-70% in coming years despite high real interest rates (i.e. adjusted for inflation).
  • The other great challenge is to bring down inflation, still close to 23% year-on-year. The central bank has set the policy rate to nearly 30% (12% in real terms) but this measure will only work slowly. Further reductions in utility and transport subsidies will keep inflation very high in coming months.
  • However, 2018 will see a new approach to wage negotiations which will seek a nominal settlement with a ‘trigger’ to protect workers if the central bank fails to bring down inflation. This should break indexation and start the long journey towards low double digit price rises.
  • The current account deficit will likely stay in the 4-5% of GDP range for coming quarters, which reflects the increasing investment expenditure and gradual fiscal adjustment. But with foreign direct investment and equity issuance only just starting, a benign global environment should help secure this funding. A range of investors such as US banks are currently restricted from investing but should soon be able to place money in the country. At some point the real exchange rate will have to adjust to a weaker equilibrium, but that appears to be a dynamic for later in 2018.

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

ESG:

  • Given the rapid policy reform and heavy focus on growth, ESG considerations have taken a backseat for now. Nevertheless, more will be needed over the longer term, providing the inequality that fuels Peronist governments doesn’t re-emerge. That said, there remains a growing focus on social as well as commercial infrastructure, most notably in Argentina’s G20 Presidency which started last week.
  • Pleasingly the agricultural sector has made some efforts to adopt approaches such as no-till farming to limit environmental costs, with policy-makers in that sector thinking about long-term stability. However as we heard from NGOs, we need to carefully monitor the risks to land and water security from the expansion in lucrative sectors like fracking and lithium mining.
  • At present, most economic policies are focused on cyclical growth, but efforts to deepen credit and promote financial inclusion will be important to spreading growth dividends more broadly.

INVESTMENT IMPLICATIONS:

  • Despite a strong and sustained rally, further gains appear possible in hard currency government and corporate bonds, with valuations still attractive in a number of provinces whose fiscal improvements are mirroring those of the national governments. Local investors also see continued opportunities in that area.
  • Equity markets trade around 14x forward P/E2 and do not fully price the potentially positive impact of ongoing reforms, especially in sectors such as banking. Local investors now also look for opportunities in real assets, including PPP infrastructure and renewables3 .
  • In local currency bonds, we believe the next round of wage and subsidy reforms needs to be passed before we see value in longer dated nominal bonds. Shorter instruments yielding close to 30% offer high real rates and an attractive risk adjusted investment in our view.

RISKS:

  • 2018 wage negotiations will be key to cementing both fiscal and inflation adjustments.
  • Argentina will be very vulnerable to global financial shocks over the next two years, more than almost any other EM country.

URUGUAY

Politics:

  • Ruling Frente Amplio is delivering a very consensus-driven centre left platform, mixing a lot of market-based economics with some more socially oriented policy. Policy-makers highlighted the continued focus on free enterprise zones and financial services of evidence of a pragmatic and mixed model.
  • Opposition parties we met with are focused on the efficiency of the government’s delivery, including the management of public sector utilities and are not proposing radical policy changes.

Macro fundamentals:

  • The government highlighted a sizeable adjustment in the balance of payments, supported by renewable energy investment. This leaves Uruguay’s external position much stronger and helps stabilise the nominal exchange rate.
  • Combined with the second year of a new approach to wage negotiations (being copied by Argentina, above), this FX stability offers the chance to bring inflation down towards the lower end of the target range at 5% year-on-year. Nevertheless, we think this relaxed political back-drop is taking some urgency away from the central bank’s inflation targeting which we conveyed throughout our meetings.
  • This same relaxed attitude is also pervading the ongoing fiscal adjustment, which has relied too heavily on revenue raising and adjustments of the finances of public sector utility companies.
  • Nevertheless, with major FDI due in transport infrastructure and industry, growth at 3.5% year-on-year should keep the fiscal balances in check.

ESG:

  • While radical economic reform does not appear likely in the short-term, ESG policies have borne some fruit. A progressive approach to renewable energy investment has materially reduced import dependence.
  • The education sector remains a clear weakness, particularly at the secondary level, due partly to the heavy influence of teaching unions. Pleasingly, political consensus is moving towards addressing some of these issues. We met with think tanks working on innovative solutions to this problem which are now getting political air time.
  • As renewable energy investment has matured, government focus has shifted to other forms of infrastructure such as transport that will be required to make growth more regionally inclusive.

INVESTMENT IMPLICATIONS:

  • Longer dated local bonds continue to offer some value given the external stability and the potential for a further structural reduction in inflation. Major local investors continue to focus on inflation linked assets, but are also branching out into infrastructure and renewables financing.

RISKS:

  • A long lead into 2019 elections may prevent potential monetary policy and fiscal gains from being achieved.

CHILE

Politics:

  • The second round Presidential election (17 December 2017) between right of centre former President Pinera and the government candidate Guillier from the left is fast approaching. Political analysts we met with are unable to predict the all-important marginal shifts in turnout, especially after the surprise 20% showing of the new Frente Amplio (Broad Front) coalition which has appeared as a challenge to the traditional socialists. This movement bears a close parallel with Podemos in Spain.
  • Local market participants perceive the election to be very binary, and it is certainly true that a Pinera victory would likely unlock cyclical consumption and investment, taking 2018 growth closer to 4% year-on-year.
  • However, in our meetings with policy makers on both sides, we found many areas where there were not radical differences in policy vision. But clearly there is room for more pro-growth implementation under Pinera. Reassuringly Guillier would control only 30% of Congress, making it hard to push any extreme policies.

Macro fundamentals:

  • Growth has been below potential now for three years. The combined effects of a cyclical shock on the copper mining sector and well-intentioned but poorly executed fiscal reform both capped investment.
  • The deterioration in fiscal performance partly reflects the weak domestic growth environment. Our meetings with the finance ministry suggested that the deteriorating fiscal balance would not improve if the current government were re-elected.
  • Weak growth has left inflation below target, but unless we see a post-election growth downturn we would not expect further rate cuts.
  • Higher copper prices, weak growth and diversification away from oil have in fact led to a healthier current account position.

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

ESG:

  • The outgoing government of Michelle Batchelet has made material strides in environmental, education and gender policies. However, poor execution often resulted in costs to short term economic growth.
  • Given that wealth inequality is amongst the widest in the region, efforts to broaden tertiary education access have been critical, although not accompanied by sufficient efforts to raise standards and completion rates. This issue remained a hot topic in almost all our meetings, especially with the Finance Ministry but also local investors.
  • Local NGOs stressed that more is needed in terms of strengthening environmental institutions to tackle deforestation and the impact of commercial fish farming on water resources. Furthermore, the government stresses the importance of not rushing approvals for extractive projects such as iron ore with questionable long-term cost benefits.

INVESTMENT IMPLICATIONS:

  • Given the recent sizeable correction in markets, there may be value in the short-term in the Chilean peso and local equities even after the initial headline response.
  • A Guillier victory would be challenging for markets, although any excessive reaction in the currency and longer-dated local bonds would potentially open up long-term value. The policy consensus which still exists alongside low levels of debt and inflation makes this trade even appealing. Local pension funds would likely also provide support for those bonds at a certain level.

RISKS:

  • Clearly, a win for the left followed by policy grid-lock would not be good for growth sentiment.
  • Longer-term, we would be equally concerned about a Pinera administration which sharply reversed recent ESG policies in an all-out pursuit of growth, as this could have destabilising political repercussions further down the line.

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.

 


Africa's rising debt: Looking beyond the headlines

Thys Louw, Assistant Portfolio Manager

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.

Are we close to a tipping point? 

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:

1996-2005: Large scale debt relief

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.

2006-2014: Africa Rising 

 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.

2014-2016: The shale revolution and economic crisis across emerging markets

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

Where to from here? 

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?

Risks and Opportunities within Africa

Looking across the African continent we can split our economies into four broad categories.

  1. Reformer - High debt levels, but declining twin deficits with strong external and multilateral support:
    Currently Ghana, Egypt, Gabon, Nigeria, Morocco and Zambia (and to a lesser extent Tunisia) are undertaking aggressive fiscal reform programmes, often supported by the IMF and other multilateral lenders. 
  2. Steady as she goes - These countries still have sufficient balance sheet space to support moderate borrowing without endangering debt sustainability:
    Countries such as the Ivory Coast, Rwanda, Namibia and Uganda have all seen some widening in fiscal and current account deficits but these remain at manageable levels.
  3. Betting on Growth - These countries have seen debt levels rise on the back of increased infrastructure expenditure, which will require a sharp pick-up in economic growth to be sustainable, otherwise deficits will need to be cut faster than planned.
    Too much of a good thing often has consequences, and that’s why in countries such as Kenya and Ethiopia we remain cautious and we avoid investment here. 
  4. Fragile - These countries generally have very high debt levels and we are yet to see a sufficient decline in economic imbalances: 
    Angola and Mozambique are among those we continue to avoid as we are yet to see sufficient progress on economic reform needed to sustainably lower debt levels. Increased fiscal consolidation and progress negotiations with multilateral partners, such as the IMF, must happen before we consider investment.

Implications for positioning

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.

3 Implemented in 2005 the MDRI was intended to supplement HIPC by providing debt relief to low income countries in attempt to support countries in meeting the Millennium Development Goal of halving poverty by 2015. Although similar, the MDRI differed from HIPC because it did not propose any parallel debt relief on the part of official bilateral or private creditors, or of multilateral institutions beyond the IMF, the International Development Association (IDA) of the World Bank, and the African Development Fund (AfDF).

 


Venezuela: Still walking on a tightrope

Vivienne Taberer, Portfolio Manager

Brief update on Venezuela:

  • The situation around Venezuela continues to be fraught with uncertainty.
  • Scheduled talks between the government and the opposition that had been delayed, now seem set to take place in the Dominican Republic again in the next week or so.
  • It is unclear whether any agreement or progress between the parties is possible – the government is trying to secure approval for a refinancing/restructuring, while the opposition is set on trying to ensure elections are free and fair.
  • PDVSA and sovereign credit default swaps (CDS) have been triggered, however it is likely to take some time for the process to be finalised and before the auctions take place. The amount of sovereign CDS is substantially larger than that of PDVSA, and is thus likely to have more impact on sovereign bond prices as the market determines which securities are cheapest to deliver.
  • Regardless of what happens with CDS, it seems unlikely that bond holders will accelerate proceedings as they still forecast a relatively high probability of receiving their coupon.
  • The ratings agencies have downgraded the country, with S&P putting Venezuela in default and Fitch downgrading PDVSA to restricted default.
  • The bondholders meeting in Caracas was poorly attended and provided no useful insight into the government’s strategy.
  • That said the government has continued to reaffirm its intention to pay it current obligations, with the stated owned utility company Elecar’s coupon being confirmed as paid. Venezuela and PDVSA have said that the coupon payments have either been or are being made.
  • We do not expect that there will be confirmation of payment receipt over the next day or two.
  • The Venezuelan government has indicated that it will pay all its 2017 commitments, but will continue to look to refinance/restructure in 2018.
  • The Emerging Markets Traders Association announced on Wednesday that the bonds should continue to trade with accrued interest, i.e. normally, as though they have not defaulted.
  • Prices remain volatile, but are well off their recent lows.

Positioning

  • We used the market bounce midweek to exit our position within our EMD Blended strategies and we are now zero weight.
  • Within our dollar debt strategy we tweaked our curve positioning into shorter-dated PDVSA bonds to keep risk vs benchmark as close to neutral as possible given the volatile and unpredictable situation.

 


As America turns its back on free trade, emerging markets forge ahead

Roger Mark, Product Specialist

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.

Unfortunate delay in RCEP agreement, although deal still likely

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).

Emerging markets have a key role to play in global trade growth recovery

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.

 


Venezuela - 'Refinancing or restructuring'

Vivienne Taberer, Portfolio Manager

What we know:

  • Last week President Maduro announced that Venezuela was transferring the funds for the payment of the principal and coupon of the PDVSA 2017 bond. PDVSA is the state-owned petroleum company.
  • He simultaneously said that Venezuela ‘would refinance and restructure’ its external debt going forward.
  • Maduro strongly suggested they might not fulfil their commitments, but that authorities would make decisions based on the perceived risks of bondholders seeking to accelerate repayments. He announced a presidential restructuring and refinancing committee to be led by Vice President Tareck El Aissami (who has been sanctioned as a narco-trafficker – which further complicates the issue).
  • There is still no real clarity on what this means and whether or not they would cease future payments, but on Friday Mr El Aissami stated that they would keep paying for now.
  • The market will therefore need to watch how they handle their upcoming coupons and those in the grace period.
  • There is also a reasonable possibility that the government could opt to pay PDVSA and default on Venezuela – given their desire to protect the state-owned oil company’s assets and there being no cross default between the entities. This is made more probable given the government just paid the PDVSA 2020 amortisation and are paying the 2017 maturing bond.
  • There is also an argument that from Venezuela’s perspective, a selective default could be a credible threat to incentivise investors to accept a restructuring proposal rather than face a lengthy legal battle.
  • Given the sanctions it seems that even if it were their intention, Venezuela would find it very difficult to launch a voluntary distressed exchange like Uruguay’s one in 2003. There could however be a few avenues the government could attempt to pursue, i.e. amending terms on existing bonds with the consent of the bondholders, issuing bonds for food and medicine and issuing to non-US investors.

Impact on bonds:

  • Prior to the announcement Venezuela and PDVSA had a weighting of 1.5% in the EMBI Global Diversified Index, and the Venezuela sub-component of the index level fell 25% on Friday. Venezuelan bonds finished the day at around 1.1% of the index.
  • A default would not see them excluded from the benchmark – they would however be excluded if the bonds no longer met liquidity requirements.
  • For comparison, Argentinian bonds remained in the benchmark post the 2001 default.
  • Prices have fallen sharply, with the higher priced, higher coupon bonds falling the most.
  • We have modest holdings in our EMD Blended and Hard Currency strategies of low coupon, low dollar priced, predominantly PDVSA bonds, which we had been starting to gradually sell out of.
  • The mix of our holdings means that although these bonds experienced an absolute fall in value, relative to the benchmark our holdings have performed well.

Our strategy from here:

  • We will continue to monitor the news and price action very closely and will conduct ongoing analysis prior to making any trading decisions.
  • Where possible we will look to reduce and mitigate risk, either by lightening up in bonds which we think are expensive relative to the rest of the PDVSA/Venezuela universe or switching from expensive to cheaper bonds.
  • Using the information available at the moment, we are more constructive on PDVSA rather than Venezuelan sovereign debt.
  • Although bonds may trade lower over the short term, we do still believe that the majority of issues are now trading below expected long term recovery values.

 


Xi embeds his power and reaffirms policy direction

Mark Evans, Analyst, Emerging Market Fixed Income

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.

 

 


Local currency emerging market debt: One of the few remaining pockets of value

Peter Eerdmans , Co-Head of Emerging Market Fixed Income

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.

Across many EMs inflation is now at record lows

  Current consumer price index (CPI)2 10 year CPI average
Russia 3.3% 9.0%
Brazil 2.5% 6.2%
India <2% >8%

 

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

 

 


Nigeria – Seeing the light at the end of a very long tunnel

Thys Louw, Assistant Portfolio Manager

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.

Consequences of bad economic management:

  • Nigeria suffered a severe erosion of its foreign exchange reserves following the oil price collapse between 2014-16.
  • Authorities sought to prop up the naira at unsustainably high levels, although their efforts did little to stem capital outflows and prevent the economy from falling into recession.
  • By the end of March 2017, a total of eight exchange rates existed, inflation stood at 17%, there were three consecutive quarters of negative economic growth and Nigeria had been kicked out of all main emerging market debt indices.

Where are we now?

  • After a series of policy mistakes, in April 2017 the government finally announced a credible and practical mechanism to attract some inward investment from offshore investors.
  • An investors and exporters (I&E) window enables market participants to set market clearing exchange rates for the naira instead of relying purely on a fixed exchange rate regime.
  • This has gone some way in eroding the differential between official and black market exchange rates.
  • The creation of this exchange rate has had an immediate impact on growth indicators and domestic confidence, with PMIs, inflation expectations and the equity market all heading in the right direction.
  • While the country is not nearly of the woods yet, it is reassuring to see some return of sensible economic decision making.

How are we capitalising on this opportunity?

  • We recently initiated a position in dollar debt in our core blended EMD and some frontier portfolios at attractive levels, which should be supported by the improvement in economic growth, increased supply of foreign exchange and the recent rise in oil production.
  • We also recently initiated a modest position in Nigerian t-bills to gain exposure to the naira in permitted portfolios. These securities offer yields of approximately 23% (at the time of writing) and with the external picture being helped by the revival in oil exports and the implementation of the I&E window, the risk/reward opportunity looks attractive.

 

 


Argentina primaries: A promising, market-friendly result

Vivienne Taberer, Portfolio Manager

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.

Populist ex-president Kirchner underwhelmed:

  • Polling and market expectations were for Kirchner to win by several percentage points in the Buenos Aires province – the industrial heartland of the country and a key support base for her populist agenda
  • However, she ended up effectively tied with the Cambiemos candidate (from Macri’s party) on just over 34%
  • More generally the fragmented Peronist factions across the country fared relatively poorly
  • Thus there was little from the result to suggest that Kirchner can return as president in 2019

Conversely it was a decent result for President Macri’s Cambiemos:

  • the elections were a symbolic test of support for Macri’s reform agenda and the better than expected result across the provinces were very encouraging – in October it is conceivable they could end up winning the 5 biggest provinces (last achieved by non-Peronists in 1985)
  • Primary results suggest that Cambiemos should manage to increase their seats in the senate by 8-9, to approx.. 24 (33%) and about 15 in the lower house which would take them over 100 seats.
  • This would still be well short of a majority, but would nevertheless increase Macri’s credibility, giving him greater clout in negotiations

What next?

  • Provided the economy continues showing some positive momentum, there is upside to Cambiemos potential in actual election in October
  • That said, given Argentina’s election rules, Kirchner will almost certainly qualify for a senate seat. This will give her a platform and immunity from prosecution. However, unless we were to see material changes her high rejection rate make it unlikely she could reclaim the presidency in 2019
  • Conversely, if the result is confirmed in October, Macri will have greater clout in pushing through the next slew of reforms that are required
  • While there is clear a reform pipeline for after the election, including tax amnesties and labour market reform, much will be dependent on how Macri balances these objectives with his desire to secure a second term for Cambiemos

Current investment views:

  • We remain constructive on the Argentine peso. The prospect of further reforms and improving fundamentals should underpin investor confidence and keep the currency appreciating in real terms.
  • Inflation remains stubbornly high and BCRA has kept its benchmark rate elevated (26.25%) as it fights to establish credibility and bring down market inflation expectations. Given the lack of progress on anchoring inflation expectations, we prefer the floating rate notes at present.
  • We’re positive on the country’s dollar debt – the elections are a credit positive and we should start to see the market pricing in ratings upgrades for later in the year.

 

 


Barriers for entry slowly collapsing in Chinese bonds

Wilfred Wee, Portfolio Manager

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.

What’s changed?

  • CHKBC operates in a similar way to China Hong Kong Stock Connect by using a platform, based in Hong Kong, to create two-way flows between the mainland and abroad. The platform caters for investments in Chinese government, agency and corporate bonds.
  • Operational requirements for institutional investors looking to invest in Chinese bonds are now much less onerous than previous systems. It will now only take approximately three days to set up a trading account and there will be no need to appoint an onshore custodian.
  • Investors can participate in CHKBC using foreign currency and conduct the currency conversion with an approved counterparty in Hong Kong which can access the onshore market. This essentially means that there is no longer any basis risk using CHKBC, unlike previous systems.
  • Market participants can now settle trades at T+2, instead of T+0 or T+1.
  • The initial impact in terms of portfolio flows will probably be limited, but this will likely grow with time as more investors adopt CHKBC as their primary route for onshore bond access.
  • The three previous systems of bond market access will remain (CIBM, QFII and RQFII), yet their importance will likely be superseded with time as new investment vehicles use CHKBC to trade Chinese bonds.
  • International investors only own approximately 1.25% of outstanding Chinese bonds, yet this will likely increase materially over the coming 5-10 years.

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.