Emerging market debt staged a welcome recovery in the fourth quarter. Up until then various headwinds had prevailed, including negative news flow from Argentina, weakness in Turkey, US-China trade war tensions and US dollar strength. The final quarter of 2018 saw both Argentina and Turkey recover, supported by improving fundamentals in both markets. As for the US-China trade dispute, while it is too early for us to dismiss the risks of a further escalation, the news flow was encouraging on the whole, with Trump saying that progress is being made. And the US dollar, which had appreciated throughout the year, weakened in December as the US Federal Reserve commented on a more muted outlook for growth and told markets to expect two rate increases in 2019, rather than three.
A key development during the quarter was the fall in the oil price, which had risen by 30% for the year to early October. Concerns about a supply glut saw the oil price weaken, and it failed to recover despite OPEC’s decision to cut production. This impacted emerging markets as currencies of oil importing countries, particularly Asian economies, benefited while sovereign spreads in some of the oil exporters, particularly in high yield space, came under pressure.
In Latin America, Mexican assets had a turbulent quarter. Concerns after the new president scrapped a major infrastructure project prompted a market decline. However, later in the quarter assets regained some ground as the market welcomed a relatively prudent budget announcement. And in Brazil, Bolsonaro won the presidential election in October and his economic appointments and comments on social security reforms have boosted sentiment.
Our outlook for emerging market fundamentals remains relatively positive, leading us to maintain a constructive longer-term outlook for the asset class.
Despite cooling, the global economy is still growing at a relatively healthy pace and emerging markets on aggregate are still early in the cycle, with plenty of slack in many economies. This provides room for growth to accelerate without stoking inflation or causing a deterioration in trade balances this year.
In the short term, it remains a relatively challenging environment, with growth indicators generally disappointing. However, developments at the margin have been positive – as mentioned earlier in relation to the US-China trade dispute and the outlook for US monetary policy, and with oil stabilising.
From a top-down risk perspective, we prefer hard currency bonds to local bonds, given value in the EM dollar spread and yields that are near post-global financial crisis. We also see value in emerging market currencies, and with news on US-China trade and US monetary policy improving at the margin we think there is room for further appreciation in the near term.
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With the global economy cooling down and US interest rates approaching a likely peak, a new cycle in emerging markets is appearing on the horizon. We have analysed past cycles in an attempt to assess what they can tell us about the next chapter for emerging markets.
There have been two starkly different cycles in emerging markets over the past 15 years: a stellar ascent from 2003 to 2012 and a largely disappointing era from 2012 to 2018. These earlier regimes have a lot to tell us about what to expect from the next cycle, though we think investors anticipating a repeat of either period will miss the mark.
China’s once-in-a-generation transformation, coupled with the forward march of globalisation, underpinned the 2003-2012 cycle. Exceptionally low asset valuations at the start of the period and later, the post-financial-crisis stimulus measures that drove investors towards risk assets created a recipe for a decade of spectacular returns from emerging markets. Yet the commodity-fuelled boom masked underlying fragilities.
The strong growth during this period meant that some emerging market economies left structural reforms incomplete and backtracked on fiscal prudence. Currency appreciation also left some markets uncompetitive, leading to worsening current account deficits. And credit bubbles began to form in some countries. Beneath the double digit returns in emerging market debt lay shaky foundations for the next cycle.
An allocation to emerging market debt today is a very different investment than it was either in 2003 or 2012.
The 2012-2018 cycle was characterised by disappointing returns as emerging economies faltered. The process of unwinding the extraordinary monetary stimulus following the financial crisis was a persistent headwind, while performance was further undermined by stretched valuations at the start of the period.
Weakening growth prompted a sharp rise in fiscal deficits. Credit bubbles burst in some countries. Then followed a period of fiscal consolidation and structural reform, as emerging market economies adjusted.
Behind the lacklustre returns of this cycle lie some important developments in emerging economies that should, in our view, support emerging market assets in the years ahead.
One of the striking lessons from examining the last two decades in emerging markets is that investors – and governments, for that matter – have a habitual tendency to anchor their expectations in the too-recent past. Just as talk of decoupling and assumptions of continual rapid growth were far too optimistic at the end of the stellar cycle, in our view many investors are excessively pessimistic about emerging markets now.
Perhaps more importantly, a narrow spotlight fails to illuminate the slower-burn transformations that have taken place beneath the ups and downs of markets. A wider lens highlights that an allocation to emerging market debt today is a very different investment than it was either in 2003 or 2012.
Quietly and gradually, emerging markets have been maturing and – nearer-term gyrations notwithstanding – we believe they are now positioned for sustainable growth.
Having worked through fragilities in the recent cycle, we believe emerging market fundamentals are now in a much better position again and valuations do not reflect this strength. Keep an eye on the Emerging Perspectives area of our website for a forthcoming paper on this topic.
Head of Fixed Income and Co-Head of Emerging Market Sovereign & FX
In North Asia, the main developments continue to centre around US-China trade negotiations against a backdrop of slowing growth momentum, in part due to the uncertainties surrounding trade.
While much remains to be clarified, the news flow suggests both the US and China are working towards some form of deal. We take a more constructive view for the time being, expressed through our overweight positions in the Chinese yuan, Korean won and Thai baht.
The market’s pricing out of US Federal Reserve rate hikes is a positive for economies dependent on capital inflows. This provides a tailwind to our modest overweight in the Indonesian rupiah.
We temper our more constructive views on trade dynamics with expectations of challenging activity data over the next few months. Headwinds in early 2019 include: a high base from a year ago; weak global growth momentum; and the hangover effects from the frontloading of activity ahead of a potential tariff escalation between the US and China, which boosted activity in the final months of 2018. We believe Taiwan will be the most sensitive of all emerging markets to this dynamic, as has been reflected in the latest PMI and export orders data. Consequently, we decided to fund our overweight positions in the Korean won and Chinese yuan out of the Taiwan dollar, which offers protection to the portfolio in the event of no trade deal being struck between the US and China.
We also see the small, open Singapore economy as vulnerable to global trade dynamics and cut our overweight to the Singapore dollar, while extending our underweight in the Philippine peso where the underlying current account dynamics remain challenging.
The situation in India remains highly fluid, following the resignation of the central bank governor and the state election defeats for the ruling party BJP. Core inflation continues to run uncomfortably high, fiscal slippage risks remain significant, while the output gap has virtually closed, leaving little room for the central bank to ease monetary policy further.
With the market pricing in interest rate cuts, there is a lot of positivity already reflected in Indian asset valuations. Nevertheless, headline inflation is running well below the 4% target, thanks to surprisingly weak food price pressures, while more contained oil prices have helped to mitigate external pressures. Furthermore, significant purchases of bonds by the central bank to maintain durable liquidity close to zero is keeping bonds well supported. Consequently, we remain neutral on Indian interest rates for the time being. We are also neutral on the currency, with oil remaining the dominant driver of performance.
Overall, the theme for Latin America continues to be one of economic outperformance relative to much of the rest of the world. With most major markets early in their business cycles and with much of the region’s election and political uncertainty reduced in 2019 (especially for Chile, Colombia, Brazil and Peru), growth data is tending to surprise modestly to the upside. We are expressing this trend through overweights in the Brazilian real, Chilean peso and Peruvian soles. At the same time, efforts over the last few years to rebalance economies have left the region with lower levels of inflation: inflation is at or below target in Brazil, Chile, Colombia and Peru. We are also expressing this regional theme via bond overweights in Brazil, Colombia and Peru across our strategies and hedged Chilean bonds in our local total return strategy
Overall, the theme for Latin America continues to be one of economic outperformance relative to much of the rest of the world.
Argentina continues to make good progress under its IMF programme, with considerable current account rebalancing, modest easing in inflation, reduced capital flight and outperformance on the 2018 budget targets. However, the cost of this adjustment programme has been a sharper than expected fall in growth, and this means there will be risks around elections later in 2019. We prefer to recognise the positive adjustment trends via a sizeable position in Argentine USD bonds.
The situation in Mexico remains complicated, after the incoming AMLO administration spooked the market in the fourth quarter of 2018 with a series of policy ‘consultations’, the government has made greater efforts to ensure orthodoxy via a solid budget proposal (albeit one we expect it to struggle to deliver). It is important not to become too bearish on the new government, but we do expect structural deterioration and after the recent rally, we decided to fund our bullish view on much of the rest of the region via modest underweights in Mexican peso and long-dated Mbonos.
Other credit markets in the region have also seen significant idiosyncratic developments over the last month. The prospect of regime change in Venezuela has risen again since December with a new National Assembly leader being recognised by the US and other countries as an interim president. We remain sceptical while the military remains loyal and maintain a market weight in our EMBI-benchmarked strategies via PDVSA bonds.
Costa Rica has stabilised its short-term position with fiscal reform following a liquidity crisis in the second half of 2018, whilst Ecuador now appears close to a programme with the IMF, and hence we believe both credit markets offer value.
We continue to focus on the political developments in West Africa. Nigeria is gearing up for what is expected to be a very tightly contested election, with the incumbent President Buhari battling against former vice president, Atiku Abubukar.
Atiku has been on the road proclaiming his business-friendly views and intentions to liberalise the exchange rate and privatise the national oil company. We consider this merely pre-election posturing and any candidate will have to deal with the economic and political realities that are involved with presiding over Nigeria.
In terms of positioning, we have added a hedged Nigeria T-Bill trade as this currently pays over 7% for no currency or duration risk and the position could also benefit from any uncertainty regarding the future path of the naira.
In other West African politics, we saw the release of former Ivory Coast president, Laurent Gbagbo, from the International Criminal Court after proceedings failed to result in a conviction. This complicates the political picture as we head towards the 2020 elections, but we are encouraged by the strong fundamental progress made by the economy and therefore continue to hold our exposure in the hard currency bonds.
Egypt continues to perform well under the IMF programme, with the latest reform focused on further liberalisation of fuel prices which we expect will allow the IMF to release a further US$2 billion in funds. We also await further dollar debt issuance and the possibility of euro-clearable local issuance later in the year which should support financial flows and the Egyptian pound. We remain long both the currency and hard currency bonds.
Egypt continues to perform well under the IMF programme, with the latest reform focused on further liberalisation of fuel prices.
Because of the sharp slowdown in Eurozone exports in the second half of last year, interest rate expectations across European markets and CEE in particular have been revised significantly lower.
The drop in manufacturing and new export orders combined with high levels of uncertainty regarding ongoing trade disputes and Brexit prospects had a large market impact on export- oriented small economies in the region.
In the Czech Republic, market rates shifted rapidly from discounting additional interest rate hikes to pricing in a cut over the next six months while in Hungary, interest rates fell sharply despite the central bank communicating the beginning of monetary policy normalisation. In Poland, the scope of repricing was much less given that rate expectations were already very low; hence, downward pressure on rates was channelled into longer maturities.
We have reduced directional risk in the region as weak activity data is now broadly reflected in asset prices, except for Romania where we maintain our strategic underweight position on the back of a sharply deteriorating fiscal position and rising financing risks.
Currencies in the region have been weaker versus the US dollar but stable against the Euro. In terms of sovereign credit markets in the region, we maintain our overweight exposure in our high conviction markets including Hungary, Croatia, Serbia and Georgia funded out of Romania, Poland and Lithuania.
Eastern Europe and the Middle East were relatively quiet on the geopolitical front after the flaring up of Russia-Ukraine tensions in November when Russia blocked Ukrainian navy vessels from entering the Kerch Strait and then arrested a number of sailors. Ukraine’s president, Petro Poroshenko, reacted strongly to this by getting the Rada to pass State of Emergency laws for much of the country. However, this was largely seen as a ploy to boost his ratings ahead of the March 2019 presidential elections.
Meanwhile the threat of new Russian sanctions came and went over December, much as we had thought it would. That’s not to say sanctions are off the cards, but rather that we believe the risk and impact on local Russian sovereign debt was overpriced. As such we continued to hold our overweight in these bonds.
Growth indicators in both Russia and Ukraine indicate a modest slowdown, consistent with what we have been seeing across Europe. More positively for the Ukraine, though, the Rada passed the 2019 budget, and this paved the way for the IMF to approve a new Stand-by Agreement as well as the first tranche, a payment of US$1.4billion to be made in January. The good news was supportive of our overweight in Ukrainian dollar bonds, although they traded poorly into year-end as markets weakened.
In Turkey we continued to hold our underweight position in the lira – even though we are seeing a very sharp correction in the current account due to a collapse in the economy (and thus lower imports), the country is experiencing severe capital account outflows as the banking and corporate sectors deleverage and pay back or do not roll external debt borrowings. Even so, the currency was relatively stable through December, withstanding several negative headlines including the US decision (later reviewed) to pull out of Syria. With local elections coming up in March 2019, the government has vigorously upped its effort to get growth back on track by cutting taxes and admin prices and hiking the minimum wage by 26%. This fiscal loosening makes us wary of the back-end of the local curve, and sovereign dollar debt.
South Africa’s troubled state-owned enterprises were brought back into light, although ironically through another series of rolling electricity black-outs. Eskom, the state electricity provider released very poor first half results and indicated that ultimately its survival depended on support from government in the form of a substantial tariff hike, workforce reduction and the government taking on R100 billion of Eskom’s R400 billion-plus debt pile.
We think this is unlikely to happen soon, especially given that general elections take place in May this year. However, we also believe strongly that the government will ultimately have to support the entity and that the debt burden will fall on the sovereign one way or another. As such we continued to favour Eskom dollar debt over South African sovereign dollar debt.
The main news out of the Middle East revolved around the OPEC/OPEC+ meetings in early December with an agreement reached to cut oil production by 1.2m bpd, tellingly brokered by the Russians. The burden of production cuts falls on Saudi Arabia, and early indications suggest the country met its December target of 400k bpd cut in production. The rest of OPEC+ begin to cut production in January and we will closely monitor compliance.
The main news out of the Middle East revolved around the OPEC/ OPEC+ meetings in early December with an agreement reached to cut oil production.
We stay long in Saudi Arabian dollar bonds. Spreads are trading wide considering the rating, while Gulf Co-operation Council (GCC) inclusion in the EMBI index and substantial fiscal buffers will help to mitigate upside supply risks, in our view. We prefer it to Qatar which is trading at tighter valuations, and we see little value in Kuwaiti or U.A.E. spreads at current levels.
Oman saw its rating cut by Fitch to BB+, a move which led to its removal from the investment grade universe. While we were not expecting the downgrade, it was also not entirely surprising, and spreads were already trading wide of a BB rating. We continue to hold our position as we believe the post-downgrade sell-off is overdone and it is trading wide of similarly rated oil exporters, despite its relatively high fiscal buffers.
Elsewhere in the region we continue to own Jordanian dollar bonds. We believe recent progress on tax reforms should re-engage the IMF, while substantial grant support from allies and local issuance should mean it doesn’t need to tap international debt in 2019. Meanwhile, the external side is supported by lower oil prices and should benefit further from a tilt into cheaper energy imports from Egypt and Israel.