On a recent research trip to sub-Saharan Africa, we included a visit to Kenya to gain a better understanding of the country’s economic health after a disastrous 2017. Whilst there, we met with the central bank, IMF, Ministry of Finance, advisers and a domestic stock broker. Each helped form a unique insight into Kenya’s economy and we left feeling somewhat confident a recovery is finally beginning to take place.
2017 was a year to forget for Kenya. A combination of a mismanaged national election, drought, weak economic growth and a restrictive interest rate cap on debt were all factors weighing on the government’s debt balance, the current account deficit and economic growth.
Our trip, however, helped paint a different picture with cyclical factors laying the foundations for a mild economic recovery.
After a severe drought which saw food imports spike to 3x their historical average, the return of rain to the main food producing areas will help bring significant relief to the Kenyan economy. Agriculture accounts for almost 25% of GDP, and remains an important source of income for a large part of the population. The lower burden from food imports and some pick-up in agricultural exports will also help offset the impact of strong oil prices on the trade balance (Kenya is a net oil importer).
Despite the circus that was the Kenyan election, risks are now mostly in the rear-view mirror with Uhuru Kenyatta confirmed as president at the tail end of last year. Despite the opposition leader likely to continue making some noise, we expect to see a revival in business and consumer confidence. Increased political clarity will also help promote foreign direct investment which was severely lacking last year. The improvement in the political climate will not only assist in spurring investment, but should also support industries such as tourism. A recent announcement of direct flights starting from the United States signals increased foreign confidence in Kenyan political stability.
The implementation of a cap on the amount of interest being charged by banks (4% above the policy rate) has had a serious impact on Kenyans’ ability to obtain credit and only amplified the economic slowdown. However, our meeting with policymakers confirmed they are looking to amend the design of the cap, after lengthy discussions with banks to ensure that credit does start to flow once again. Over time, we expect its removal or amendment will help in restoring credit growth.
For some time now, we’ve seen a persistent unwillingness to address the fiscal deficit which is starting to put pressure on the relationship with multilateral donors like the IMF. Historically, Kenya has been entitled to almost US$1.5 billion in emergency credit. Our meeting with the IMF suggested the country would be unlikely to have this agreement renewed in its current form until the government starts to take serious measures aimed at tackling the fiscal deficit. We do, however, expect that the relationship with the IMF will continue, but the terms of the agreement will most likely change.
Despite the government’s ambitious capital expenditure programme being a positive for the long-term health of the economy, over the short term it places continued pressure on debt sustainability. It also implies the government is placing a one-sided bet on economic growth, which needs to start materialising over the next 3-5 years to ensure the debt rebalances to more sustainable levels.
Subsequent to our trip, Kenya came to the market with a 10- and 30-year euro-bond issuance. The market focused on the potential non-renewal of the IMF programme, and these securities were priced at a significant discount to similarly rated peers. We participated in the deal as this issuance offered exposure to an underappreciated and ignored story, while economic growth and the fiscal and current account are likely to improve materially this year.
We will continue to keep you updated on developments in the region and believe frontier opportunities like these add significant diversification benefits for our clients’ portfolios.
The last couple of weeks have been busy for China watchers – from the announcement of the removal of presidential term limits to Trump’s tariff announcements and the opening of the two-week National People’s Congress (NPC) at the weekend. Here are the key investment takeaways from the last week:
China GDP nowcast
Source: IAM, Haver, Bloomberg as at 28 February 2018. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: IAM, Haver, Bloomberg (as at 28 February 2018)
Trade war risks and a strategic opportunity for China
The ending of term limits poses concerns over the long term
I recently visited Delhi and Mumbai on a two day tour of India, meeting with a number of public sector officials, local private financial institutions, a political journalist and rating agencies. The timing of the trip was ideal, given the recent presentation of the Budget and the Reserve Bank of India’s (RBI) Monetary Policy Committee meeting.
These research trips are an invaluable part of our proprietary research and analysis, getting the view ‘on the ground’ which we wouldn’t necessarily have by staying at our desks. My trip to India was no different, and while there were lots of learning points, I highlight below the three key takeaways which I think are the most underappreciated by the market.
With legislative elections due around May 2019, these are now starting to appear on peoples’ radars. While there is a long way to go, the political analyst I spoke with expects the ruling Bharatiya Janata Party’s (BJP) to win the election, but lose its absolute majority by some distance. If this materialises, the BJP will become more reliant on their coalition partners which would likely throw more sand in the wheels of reform, disappointing those with the long held structurally positive view on India.
What was interesting is this loss of appeal appears more directed at the BJP than Prime Minister Modi, whose popularity remains very high. The government officials I spoke with appear very aware of this falling popularity and hence their number one priority for this year is growth. Upcoming local elections will be a good barometer of how much the Modi appeal and growth improvement sticks with voters. Relative to expectations, it feels the risks are skewed to the downside.
The local financial institutions I spoke with remain very reluctant to buy Indian government bonds, despite the sharp correction in yields over the last six months. While fundamental concerns are well flagged (higher oil prices, better growth, higher inflation etc), the recent RBI comments suggest they would not interfere in the bond market which effectively prompted a buyer’s strike. To offset this, the local financial institutions are hopeful that the central bank will increase the limit available for foreigner portfolio investors (FPIs) to invest in the bond market from the current 5% level. The RBI is due to announce the new limits towards the end of March/early April. The central bank previously supported increasing these limits providing the fiscal position was improving. However, fiscal consolidation has recently stagnated, and the budget announcement did not offer much comfort. Hence, there could be more disappointment in store for local financial institutions.
It remains well understood that Public Sector Banks (PSBs) in India have significant balance sheet issues which the government is trying to clean up by recapitalising them. Despite these government efforts, my discussions with rating agencies confirmed my previously held view that the magnitude of the recapitalisation is insufficient. This could delay the growth recovery beyond market expectations and add more pressure on the government’s finances through bigger capital injections.
Overall, there is growing uncertainty over the future path of the Indian macro story. There are important external factors to consider (oil prices, Fed policy etc) which can significantly impact the short term outlook for India, but the internal dynamics appear to be deteriorating relative to market expectations. Consequently, we retain our short positions in the currency and interest rate markets (in portfolios permitted to do so).
We recently completed a Zambian research trip, researching economic policy, politics, IMF programmes and debt sustainability. I had gone into the trip with a marginally positive view on fiscal progress made under the then Finance minister Felix Mutati, but unfortunately came away with serious concerns. The deterioration in local politics means that an IMF programme is unlikely as authorities remain reluctant to deal with the issues of external debt and public financial management that endanger debt sustainability. A cabinet reshuffle announced on the first day of our trip raised further alarm bells given the reform minded Finance Minister Mutati was effectively demoted to minister of supply and works. We now have little exposure to Zambian assets within our emerging market debt portfolios, believing the risk/reward opportunity is much more attractive in other parts of Africa and around the globe.
Since the economic crisis of 2015, the economy’s recovery has been painfully slow despite the tailwinds from higher copper prices, rising electricity and agricultural production. The partial revival in economic growth has done little to help correct bloated external debt levels.
The government had made some progress on fiscal reform, reducing subsidies and pushing a public financial management act which would require all contracted debt to have Ministry of Finance sign-off. Unfortunately scratching beneath the surface uncovered a different reality, with the government continuing to contract debts outside of the view of the ministry of finance. In light of President Lungu’s focus on securing support for a second term there may not be enough top down support to help correct this issue. An unexpected ministerial reshuffle over the last few days emphasises this point, as does the arrest of a key opposition leader last year (he was released, but charges remain on the book). Zambia does not enjoy the same freedom of the press as neighbouring South Africa.
After 18 months of back and forth with the IMF, authorities failed to secure an IMF programme at the final minute in September 2017 due to issues around debt transparency. Upon further investigation it became clear Chinese loans were granted at a ministerial level without Ministry of Finance sign-off. The government are still unable to provide guidance on the size, tenor and terms of these loans. Estimates from our trip put the Chinese debt number at almost 30% of GDP (US$6 billion), with disbursements over the next five years. This would mean that without any additional debt contraction Zambia would need to growth at least 6% annually to just keep the debt load stable, which is a situation we feel is unlikely and puts longer term debt sustainability into question.
While imbalances in the country have improved and remain manageable over the short term with the current account and fiscal deficits 3% and 6% respectively (as a % of GDP), risks are rising. Zambian authorities continue to bleed reserves due to high external interest payments and a lack of mining flows given the accumulation of VAT arrears. In our view, this scenario is not sustainable in the long-run and without any additional external funding or assistance from the IMF the country will become more vulnerable to an external shock. Zambia could avoid some of these funding shortfalls by issuing local currency debt, although in the current environment we believe the government will struggle to attract foreign inflows.
We have now cut our modest Zambian exposure to zero across all emerging market debt portfolios and will closely follow the current situation before we consider reengaging any long positions.
By raising South Africa’s VAT rate from 14% to 15%, the South African government indicated a willingness to take difficult (and unpopular) decisions in order to stabilise the fiscus. Coupled with the recent ousting of Zuma, this Budget should be enough to keep Moody’s on hold when they release their South Africa sovereign review on 22 March 2018. If a good cabinet is appointed in the coming week, it may even be enough for Moody’s also to move the outlook to stable from negative. However, there are two concerns – firstly, that the debt-to-GDP profile does not stabilise for five years, and secondly, the public sector wage settlement that is still being negotiated.
Overall, Finance Minister Malusi Gigaba presented a plausible, conservative budget with reasonable growth assumptions that focuses on what it is delivering this year rather than making promises of future consolidation. Revenue hikes totalling R36bn are planned for the 2018/2019 fiscal year, anchored by the VAT increase, which will add a projected R22.9bn, and the zero relief for inflation in the top four tax brackets, expected to bring in a further R6.8bn.
In terms of the growth forecasts, the National Treasury’s assumption of growth at 1.5% for 2018 is at the bottom of the consensus range, and there is definite room for upside if half the structural measures announced in President Ramaphosa’s State of the Nation Address materialise.
The main budget forecasts remain higher than we would have preferred, with the primary balance, which excludes interest payments, only moving to zero in the 2020/21 fiscal year. Nevertheless, the improvements are still substantial. The 2018/19 forecast falls from 4.5% to 3.8% of GDP, while the 2020/21 forecast declines from 4.6% to 3.7% of GDP. However, if growth of 3% materialises by late 2020, this alone would move the main budget deficit to 3.4% of GDP in that year.
The improvement in the debt profile, driven by the higher revenue forecasts due to the VAT hike and higher growth forecasts, is encouraging. However, with the debt-to-GDP ratio only peaking in the 2022/23 financial year, we need to see further progress at the Medium Term Budget Policy Statement in October this year.
Contrary to our expectations, there were virtually no cuts to overall expenditure over the medium term. Instead, there is a significant reprioritisation of spending in order to accommodate the R66bn needed in the next three years to fund free tertiary education. This leaves considerable room to cut spending if President Ramaphosa’s planned merger of government departments proceeds. However, the wage increases currently being negotiated with public servants is critical – any slippage from the budgeted wage bills will derail this budget.
Ultimately, all the budget woes would be resolved if we could get growth going. For example, if we could achieve a growth rate of 3% in SA the 2020/21 fiscal year, it would push up the primary main budget balance by 0.4 percentage points. Indeed, it should not be out of reach and the Budget Review sets out a breakdown of how GDP growth of 4% could be achieved. Assuming baseline GDP growth of 1.5% currently, the following factors could push it to 4%:
The Budget was always going to be a necessary, but not sufficient condition to shoring up South Africa’s one remaining investment grade credit rating and restoring the confidence of households, investors and businesses in the economy. This Budget is good. In light of the political flux it was produced within, it is excellent. It demonstrates the depth of the skills and commitment of the Treasury staff.
The key now is whether the widely expected cabinet reshuffle puts people in charge of key Ministries that produce a regulatory environment that pragmatically encourages investment while taking into account South Africa’s social context. As the Treasury noted, a boost to confidence alone will raise growth by 0.5%. Sectoral reforms will do much more.
Structural reforms are the key to improving South Africa’s growth outlook. However, it is far more helpful if this takes place in the context of a competitive currency. In 2017, emerging markets experienced inflows of US$100bn into dedicated equity and bond funds. While flows in 2018 have been more volatile, the expectation is that they continue. Therefore it is very clever of the National Treasury and Reserve Bank to loosen exchange controls for institutional funds. The Budget Review noted that offshore limit for institutional funds is increased by 5% for all categories, including the African allowance. Therefore the African allowance goes from 5% to 10% and the Rest of World category for institutional funds goes from 25% to 30%. Total ex-SA allowance is raised to 40%. This allows savers to continue to diversify their holdings, while likely providing some offset to the likely inflows as South Africa’s potential growth rate rises.
Chinese New Year is set to arrive on 16 February 2018, leaving behind the Year of the Rooster and ushering in the Year of the Dog. What are the key themes to look out for in the coming canine-related year?
Over the last few years, we’ve seen more sovereign downgrades than upgrades. This reflects rating agencies’ belated reaction to weaker growth, softer commodity prices and the deterioration in fiscal finances that occurred during the 2013-2015 period. Despite this, the credit fundamentals of EM sovereigns have arguably improved quite materially due to recovering economic growth, rising oil prices, greater fiscal consolidation and fading external vulnerabilities. The strong rise in EM capital markets from 2016 reflects this improvement, and we believe rating agencies will naturally start to respond by lifting aggregate ratings across emerging markets (EMs) in 2018 and beyond.
As Chart 1 demonstrates, the deterioration in EM credit ratings over the last few years has been a story almost entirely of oil. Net oil exporters experienced consistent downgrades as fiscal deficits and external imbalances ballooned on the back of the collapse in oil revenues. By contrast, oil importing EM countries saw little deterioration in credit quality over the last few years (Chart 2).
Chart 1: Cumulative credit rating momentum for net oil exporters vs Brent crude oil price
Source: Moody’s, Standard & Poor’s, Bloomberg, Investec Asset Management December 2017
Chart 2: Cumulative credit rating momentum for net oil importers
Source: Moody’s, Standard & Poor’s, Bloomberg, Investec Asset Management December 2017
With oil in a US$60-70 range, the fiscal outlook for oil exporting countries is expected to improve. The inherent backward-looking nature of credit rating agencies has yet to reflect this development. For instance, Fitch have seven net oil exporters on negative watch and only one on positive watch. The following themes support our view that 2018 EM credit dynamics should improve:
Chart 3: Debt-to-GDP levels of EM economies beginning to stabilise at healthy levels
Source: Investec Asset Management, IMF, JP Morgan December 2017
The recovery in credit dynamics will likely continue to help support EM dollar bond spread compression and act as a further tailwind for the entire EMD asset class through 2018. Of course exceptions exist for countries that fail to properly reform and rebalance their fiscal budgets, but they are in the minority and such dispersion creates a healthy alpha generating environment for us as active EMD investors.
For emerging markets (EMs), 2017 represented a year of disinflationary surprises. However, in recent months this trend has dissipated and if anything inflation began surprising more positively at the margin (see Figure 1). This supported our decision to stay fairly neutral on local currency bonds over the last few months.
Figure 1: Inflation surprises beginning to turn at the margins
Source: Haver, Bloomberg, Investec Asset Management December 2017
We think overall inflation will likely see less downside momentum, although analysing the investment universe on a country-by-country basis tells a much more interesting story. Even in countries where inflation is likely to pick up, the reasons for the inflationary momentum are largely idiosyncratic, ranging from a combination of base effects, pass-through from oil prices, to excessively loose monetary policy and a reduction in spare capacity in some economies. At the same time, in some markets we expect disinflationary momentum in 2018, and risks for the asset class remain fairly benign with very few EM economies close to overheating. Thus from a bottom-up perspective, diverging inflationary trends are providing a constructive alpha generating environment.
The rise in oil prices has led to some pass-through inflation in a number of net oil-importing countries. For example, Indian fuel inflation hit nearly 8% in November, the highest since 2013. Similarly, food inflation rose significantly, and core inflation has also started ticking modestly higher. This will likely force the Reserve Bank of India to commence an interest rate hiking cycle in the first few months of 2018, and therefore we prefer to play from the short side.
The pick-up in inflation also reflects the cyclical bounce beginning to reduce slack in some EM economies. In recent years, tight labour conditions failed to generate inflation in the Central and Eastern European (CEE) region, but this may finally be beginning to change. Czech growth may have only pushed up core inflation towards 2%, but this represents a multi-year high, and has encouraged the Czech National Bank to start its hiking cycle. This keeps us generally bearish on local bonds and rates, while we are more positive in FX. Hungary also experienced a surge in core inflation this year, although headline inflation will likely remain below target for 2018, and given the central bank’s commitment to flattening the yield curve we continue to like longer-maturing local bonds.
In contrast to the Czech Republic, the Romanian central bank has been somewhat behind the curve, as our basic Taylor rule suggests (Figure 2), with inflation rising above target for the first time in four years. To date, the central bank’s attempts to control inflation by narrowing the interest rate corridor seem inadequate, with headline inflation surprising higher to 3.2% in November. This should finally encourage the central bank to raise interest rates in early 2018.
Figure 2: Romania Taylor rule suggests the central bank is behind the curve
Source: Haver, Bloomberg, Investec Asset Management December 2017 Taylor rule – This rule is an approximation tool used to estimate the responsiveness of nominal interest rates to changes in inflation, output, or other economic conditions
The lack of central bank credibility in Turkey has allowed core inflation (12%) and inflation expectations (9.3%) to hit 13-year highs. December’s rate tightening underwhelmed market expectations, and it’s likely that the FX pass-through from the weak lira will force the central bank into aggressively hiking rates in the early months of 2018.
Two markets in particular – Brazil and Russia – epitomised the disinflationary momentum over the last 18 months. Nevertheless central banks in both countries showed unprecedented restraint by only gradually lowering interest rates, therefore helping anchor inflationary expectations. This succeeded in both countries, with inflation rates moving from double digits in 2016 to below 3% now, and below or within their central bank’s targets. Naturally this trend is now beginning to slow and we should see a modest pick-up in inflation through the first half of 2018 (Figure 3).
We don’t find Brazilian local bonds particularly appealing at these levels. While we’ve been positive on Russia for most of 2017 we’re more bearish now, despite the central bank surprising markets with a dovish cut in December. We currently feel less optimistic for future interest rate cuts, with base effects creeping into inflation numbers and valuations looking somewhat stretched. Given the cyclical pick-up in economic growth and external account dynamics in both markets, we are more constructive on currencies than bonds for now.
Brazil headline CPI - dynamic PCA %yoy
Source: Haver, Bloomberg, Investec Asset Management calculations December 2017
There are other markets, particularly in Latin America, where we still see material room for inflation to fall through the coming months. Argentina remains the most extreme example, with inflation still close to 25% and the central bank keeping rates very high to try and push down inflation expectations. While we think they will eventually manage to succeed in doing this, it will inevitably take time. Given the extent of the yield curve inversion, the risk reward pay-off is much more attractive in T-bills where we can still pick up a yield of close to 30%.
Chart 4: Argentine inflation nowcast points to disinflation through first half of 2018
Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results.
Source: Haver, Bloomberg, Investec Asset Management calculations December 2017 Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
In Mexico, Banxico retained its hawkish bias, delivering a cumulative 150 basis point hike this year in a bid to suppress inflation expectations. Our nowcast points to a tick down in inflation during the first half of this year and while longer-dated bonds may come under pressure from political news, we maintain a constructive view on the mid-part of the curve. We also remain constructive on Peruvian local bonds, due partly to our views on inflation. Lacklustre growth is having some downward pressure on pricing pressures, allowing the central bank to lower interest rates. Outside of Latin America, South Africa represents another market which should experience some disinflationary momentum this year, which we expect the central bank to recognise by cutting rates during the first quarter of this year. This, combined with the market pleasing ANC election outcome, keeps us positive on the country’s bonds going into 2018.
As we have mentioned before, emerging markets (EMs) are at the start of a busy election calendar over the next 12-18 months. Election outcomes can be crucial in driving policy direction and therefore asset prices. This past weekend we had the first three of these EM elections, and all resulted in the more market friendly outcome. In the case of South Africa, this wasn’t straightforward but Ramaphosa’s victory represents a transformational moment for this young democracy and its people.
Let’s start with the least market-moving election, the local elections in two Indian states, Gujarat and Himachal Pradesh. While of limited economic impact, the elections were an important litmus test of Prime Minister Modi’s popularity and reform agenda, particularly important given the next general election is less than 18 months away. It was an encouraging victory for this party, which secured majorities in both states. Admittedly the size of the majority in Gujarat was a bit disappointing, although the BJP recorded a better than expected result in Himachal Pradesh. Overall we see the result as a positive one for the BJP, with the current trajectory of reforms likely to stay in place.
Meanwhile in Chile, pro-business ex-President Sebastien Pinera was elected after the second round of the Presidential Election. After a tighter than expected first round (which spooked the markets), Pinera easily defeated the leftist Guillier, with a projected 55% share of the vote. During four years of Bachelet, the reform agenda stalled and more populist policies were adopted. Thus the business-friendly Pinera should ensure a more pro-reform agenda in the coming years. This resulted in the Chilean peso being one of the strongest EM currencies this month, up 4.5% (at the time of writing). We remain constructive on Chile and believe we can see positive reforms, improved business sentiment and a pick-up in growth after a few disappointing years.
The most hotly contested and arguably most important election this weekend was not a public one, but the internal election for the ANC Presidency. The election polarised the ANC and indeed the country with Nkosazana Dlamini Zuma (NDZ) representing the under-fire Zuma faction, which is accused of blatant corruption and weak economic and fiscal policies, versus the more market-friendly candidate Cyril Ramaphosa. The policy differences between the two candidates meant the market viewed the outcome as binary, with a Ramaphosa win representing a return to the days of prudent macro policy and a NDZ victory symbolising a continuation of institutional decline.
As the market gained greater confidence of Ramaphosa’s victory, the rand rallied (by over 6% this month at the time of writing). Ultimately, internal divisions meant that a compromise result was inevitable. As such, despite Mr Ramaphosa taking the ANC presidency (and likely South Africa’s presidency in the next national election) the top-6 party positions were split 3-3 across the factions, with at least two deeply compromised people (David Mabuza and Ace Magashule) taking senior positions. This highlights the need for caution, and clearly we also need to see how quickly Ramaphosa’s victory translates into better policy as he balances the demands of both the nation and the ANC itself. But overall, this result is a positive for South Africa’s future.
All in all, these three results were encouraging. This may well set the scene for further positive outcomes in the busy 2018 election cycle. This combined with a strong economic growth outlook and relatively attractive valuations, should bode well for Emerging Market Debt returns in the New Year.
Figures below showing: Argentine growth looks set to remain solid, aiding the fiscal adjustment but keeping the current account deficit wide and inflation reasonably high
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Figures below showing: That despite the short-term political risk, external balances in Chile are improving as shown in the nowcast, while inflation risks remain reasonably contained
Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017 Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.
Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017
Source: Haver, Bloomberg, Banco Central de Chile, IAM calculations November 2017
1Peronism – is a brand of populist and nationalistic politics that has a history dating back to the mid-1940s in Argentina.
2As at November 2017.
3PPPs often involve a contract between a public sector authority and a private party.
While rising African debt levels occupy headlines1, we sift fact from fiction below, and discuss how we evaluate opportunities. Read more by downloading the full Viewpoint here.
Debt dynamics across the region, defined here as median gross government debt to GDP, have gone through three main cycles over the past 20 years:
Following a sharp rise in indebtedness in the 1990s, the early part of the 2000’s was a period of debt consolidation and write-offs in Africa as a result of the Heavily Indebted Poor Countries (HIPC)2 programme and its replacement, the Multilateral Debt Relief Initiative (MDRI)3.
After a sustained period of consolidation, with median debt to GDP hitting a low of 38.1% in 2008, the exponential rise in commodity prices helped stimulate growth and investment into Africa. African governments borrowed in international markets to support investment expenditure – but as deficits worsened, risk rose.
As oil prices collapsed from June 2014, accompanied by rising borrowing costs, balance sheets deteriorated. However, re-leveraging across Africa and other frontier markets (Chart 1 below) hasn’t been at the expense of debt balances, given growth.
Chart 1 – Regional Emerging Market Gross Government Debt as a % of GDP
Source: IMF WEO, IAM Calculations October 2017
The African region is expected to deleverage from now until 2022, reflecting stabilisation in commodity prices, improvement in global growth and economic reforms that were implemented during the crisis.
While the build-up of African debt balances is a risk, balance sheets should stabilise below distressed levels, providing the external environment remains stable.
With 54 countries across the region, we recognise that Africa represents a diverse investment universe; real value can be added by understanding divergences within Africa, and acting on these insights through active country allocations. So how do we differentiate?
Looking across the African continent we can split our economies into four broad categories.
The dispersion of economic fortunes across Africa represents opportunity for the discriminating. We continue to favour reforming countries and reflect this in the portfolio through positions in Egypt, Nigeria, Morocco and Zambia, where permitted. We also selectively allocate to countries such as the Ivory Coast and Uganda given their manageable debt metrics and attractive growth rates. Looking beyond the negative headlines, the period ahead still looks promising and we will continue to keep you updated on interesting trends across the continent.
1 Most prominently through the Financial Times’ article titled ‘African debt worries intensify as levels near tipping point’ (click here).
2 Is a group of 39 developing countries (33 of which are in Africa) which qualify for debt relief and low interest rate loans from the IMF and World Bank, where debts are considered unsustainable (defined as debt to exports>200-250% or when debt to government revenues exceeded 280%). Initially launched in 1996 it has provided full or partial debt relief to 36 countries.
A silver lining of the Trump administration’s protectionist agenda has been that emerging market (EM) governments have, on the whole, reaffirmed their commitment to freer trade. Reassuringly, they recognise the positive influence of open markets in driving EM economic growth over the last three decades.
While Trump stole much of the headlines from the APEC meeting over the weekend, 11 countries (including Malaysia, Chile and Peru) finally agreed to push ahead with a revised version of the Trans Pacific Partnership (TPP)*. This strongly signalled remaining participants’ commitment to trade liberalisation, despite Trump withdrawing from the agreement during his first day in office. Even without US involvement, the scale of the prospective agreement is significant – 500 million people and over US$10 trillion in aggregate GDP. That said, without US involvement, the economic gains are more modest. A recent paper from the Peterson Institute for International Economics (PIIE) highlighted the economic benefits of TPP (ex-US) would be limited to approximately US$150 billion, or less than half the benefits of the agreement with US participation. However, if the five other Asian countries that have shown an interest in the agreement were to join then the economic benefits would approach those of the original TPP according to the PIEE analysis.
Also at the weekend was a modestly disappointing delay to the other large putative Asia-centric trade agreement, the Regional Comprehensive Economic Partnership (RCEP)**. A ministerial meeting at the side-lines of the Asean summit in Manilla decided to push back the timeline till 2018 (there had been hopes it could be signed this year).
A trade deal does, however, still seem very likely. RCEP is regarded as a lower quality trade agreement than TPP (limited coverage of services & investment, and weaker labour and environmental provisions), however it covers a much larger GDP base (4 of 10 largest global economies are in RCEP). PIIE estimate global income gains of around US$300 billion and the economic benefits could be significantly higher if countries like Japan and Australia manage to succeed in getting some services provisions into the agreement. Moreover, both agreements can facilitate a framework for further rounds of gradual trade liberalisation (possibly with US involvement under a more receptive administration).
Admittedly both trade agreements have a long way to go, although the progress to date shows that the world is moving ahead with trade liberalisation despite the US flirting with protectionism. This should help to underpin global trade growth over time. As Chart 1 shows, the rate of trade expansion has been lacklustre since the financial crisis – partly reflecting cyclical factors like the sluggish pace of global economic growth, but also structural factors such as the shortening of global supply chains (particularly in China).
The stalling of the Doha round of global trade negotiations and lack of progress on regional trade agreements has also likely played a significant role in the trade slowdown. Indeed, just a year ago, considerable gloom existed among trade economists. Now, fresh progress on trade agreements, driven in part by emerging markets, could help to underpin a longer-term re-acceleration in trade growth (which has already started to pick-up somewhat with the cyclical upswing in global economic activity). Thus, while there are significant concerns around the future of Nafta and Korea-US Free trade agreement, clearly the US administration is not going to be able to reverse the long-run trend towards greater trade liberalisation, and that EM governments recognise the importance of open trade for their economies.
Chart 1: Global trade volume growth (year-on-year %)
Source: Investec Asset Management, CPB Trade Monitor, November 2017
*TPP members: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam.
**RCEP members: 10 ASEAN countries + Australia, China, India, Japan, South Korea and New Zealand.
What we know:
Impact on bonds:
Our strategy from here:
The nineteenth National Congress of the Chinese Communist Party (the Party) was held from 18 - 24 October, followed by the First Plenary session today (25 October). As expected, President Xi cemented his status as the “Core Leader” of the Party; with “Xi Jinping Thought” having been enshrined into the Constitution. Furthermore, no obvious successor exists within the newly formed Politburo Standing Committee, increasing Xi’s chances of serving past his expected retirement in 2022. Consequently, the significance of other personnel changes was diluted, but from our perspective there will be little to distract President Xi from his policy agenda for the remainder of his term.
At the beginning of the National Congress, Xi’s Work Report laid out the broad plans for the next 30 years. Nevertheless, the market will focus most heavily on what to expect over the next 12 months. In terms of policy direction and momentum, we don’t expect much of a change over the short-to-medium term.
Firstly, Xi has long been considered the most powerful president for decades, so the last week has essentially rubber stamped a process which has been evolving over the last five years and was already well understood. Secondly, and somewhat related, we have seen an impressive shift in the gears of policy implementation over the last 18 months, with a clear focus on better supply side management. This contrasted with previous years where too much emphasis was placed on boosting demand through aggressive credit growth. As a result, the need for drastic policy change is limited at this stage. We therefore expect a continued focus on deleveraging, reducing excess capacity and pollution through SOE shutdowns and tightening controls on the property market to contain overheating risks.
From a portfolio perspective, we remain constructive on the Chinese renminbi. The balance of payments is in surplus as capital outflow pressures have eased significantly. Nevertheless, we still see some evidence of disguised capital outflows and hence do not expect any imminent capital account liberalisation. Trump’s visit to China next month comes as the trade balance between the two countries continues to widen, therefore ongoing currency stability or mild strength will be in China’s best interests.
It’s been a fantastic run for local currency emerging market debt (EMD) this year – up around 15% (in US dollars)1 and on track for its best return since 2009. Despite the strong rally, we believe that at a time of stretched valuations across other capital markets, local currency EMD is one of the few global asset classes offering genuine value. Both elements of local currency bond returns – yield and FX – appear to have room to appreciate further from current levels, particularly in high yielding markets.
If we turn to yields first, the GBI-EM weighted index yield is hovering around 6% at present. This remains relatively high compared to history, but on a real (inflation adjusted) basis valuations look even more attractive. The below table highlights the scale of disinflation across some of our key markets.
|Current consumer price index (CPI)2||10 year CPI average|
Source: Bloomberg, 30 September 2017
Pleasingly, monetary authorities have shown unprecedented discipline when reducing interest rates – a function of the increasing independence of EM central banks and their adoption of explicit inflation-targeting regimes (in countries as diverse as Argentina and Ukraine). While some central banks began easing monetary policy to support their economies – particularly in recession-hit countries like Russia and Brazil – they have done so in a largely credible fashion, ensuring inflation expectations remain anchored.
Consequently, interest rate reductions have generally been quite modest which has helped keep real interest rates and local bond yields high versus history. This relationship appears particularly noticeable when we compare the real yield between high and low yielding EM bond markets, as can be seen in Chart 1. In the high yield space, real yields remain close to their highs. With structurally lower inflation being sustained by credible central bank policy, nominal yields should continue falling outside of any external shock. By contrast, low yielding bond valuations look closer to fair value, although they don’t look exorbitantly expensive relative to history.
Chart 1: GBI-EM real bond yields across high and low yielding markets
Source: Haver, Bloomberg and IAM September 2017
Chart 2: EM real yield differential over developed markets remains elevated, and above its historic average
Source: Source: Haver, Bloomberg and IAM September 2017
This real yield buffer should continue to support foreign inflows, especially considering the attractiveness of EM currency valuations. On a nominal effective exchange rate basis 3, EMFX performance this year has been lacklustre given the strength of the euro. Similarly, using the real effective exchange rate (REER) method4, EMFX also looks inexpensive compared to history, particularly high yielding EMFX5. Even after accounting for the changed macro environment, we believe EM REERs for a number of high yield currencies remain 5-10% below fair value.
Chart 3: ELMI weighted REER high yield vs low yielding currencies
Source: Haver, Bloomberg, JPMorgan and IAM September 2017
The robust growth outlook across emerging markets should support further REER appreciation over the next few months, as we are still at a relatively early stage in this cyclical pick-up. As well as positive bond flows, equity flows should also be supportive given positioning remains light (indeed there has been net selling in recent months) and the fundamentals are improving, with net income margins rising, and as Chart 4 highlights, forward price-to-earnings (P/E) ratios6 still attractive relative to history and developed markets.
Chart 4: Developed vs emerging market equity valuations using P/E ratios
Source: Haver, Bloomberg and IAM September 2017
Thus we see fundamentals, valuations and positioning all still lining up positively to support local currency EMD over the medium term. With several emerging market economies also set to benefit from an increased stock of capital, technological progress and pro-market structural reforms this allocation argument is only strengthened.
1 As at 30 September 2017
2 Year-on-year change in the index
3 The weighted average rate at which one country’s currency exchanges for a basket of other currencies, not adjusted for inflation
4 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation
5 FX valuations need to be framed within the context of the end of the commodities super cycle, which drove the structural break in EM growth to a more sustainable, but lower rate, as well as driving the deterioration in in commodity terms of trade
6 The forward price-to-earnings ratio is a company’s current stock price divided by its estimated earnings per share
Falling oil prices, an import-dependent economy and multiple policy mistakes by authorities almost tipped Nigeria into depression. Over the last two years we have had little-to-no exposure to Nigeria on the back of our pessimistic view of Nigerian economic policymaking in an environment of lower oil prices. This strategy has not only saved our clients from significant losses, but also ensured that our EMD strategies faced no repatriation risks due to significant shortages of US dollars. However, in our view, an opportunity is beginning to open up and we are re-allocating to a country with improving economic fundamentals, more sensible economic policy settings and one which is priced attractively.
The casual observer could be forgiven for thinking a real election just took place in Argentina. It was, however, just a primary – the elections only take place on 22nd October. But primaries in Argentina are quite unique – all parties take part in the same vote. Thus it provides an important gauge of the political climate in the country – the first true indication since Macri’s election victory in 2015. And the results were a positive surprise for him and investors. Give market weakness over the last few weeks, the result precipitated a strong rally in Argentine assets with the peso rallying 3% on the news and dollar spreads closing 40bps tighter as the market.
Accessing China’s interbank bond market is set to become significantly easier following the implementation of China Hong Kong Bond Connect (CHKBC) in July 2017. CHKBC forms a direct, efficient and transparent platform for offshore institutional investors to access the mainland’s debt market, and will almost certainly be the preferred bond market route for new investors. In our view, CHKBC will inevitably speed up the timing of China’s index inclusion and enable a constant flow of capital from international investors. The Chinese bond market remains a compelling investment opportunity given its yield and diversification benefits, and with operational barriers being broken down further this argument is only strengthened.
Our core EMD funds already have the flexibility to trade in China through either RQFII or CIBM direct. However, given the increased flexibility of CHKBC we can use this method for any future funds or segregated portfolios which have not yet had access to the Chinese bond market.