August was a challenging month for emerging market (EM) bonds and other investment markets. Although hard currency bonds, measured by the JPMorgan Emerging Market Bond Index, gained 0.75%, local currency bonds (JPMorgan GBI-EM index) ended the month down 2.64%, as currency weakness weighed on returns.
The US-China trade war rose to prominence again. At the start of the month President Trump announced that the US would impose tariffs on another US$300 billion of Chinese goods. Tensions increased further when China responded with its own tariffs, but towards the end of the month both sides were more measured in their rhetoric.
Another event dominating headlines was the outcome of the Argentinian primary election where President Macri suffered a surprisingly large defeat. The result weighed heavily on Argentinian assets. The government’s partial debt restructuring proposal later in the month prompted rating downgrades on the country’s debt. President Macri has since implemented capital controls in an attempt to stop the outflow of dollars – this came as little surprise; we wrote on the topic in a recent post on our Emerging Perspectives site.
Also in Latin America, the Brazilian real came under pressure - the country is one of Argentina's major trading partners, growth is already weak and the market has seen strong demand for dollars from Brazilian corporates. Environmental issues mean that trade and agricultural risks have risen (we’ve written on the Amazon forest fires here) so we are keeping a very close eye on developments there.
Over in South Africa, the rand and local bonds lost value as fiscal and economic concerns intensified. Fitch downgraded its credit outlook on the country while commentary from Moody’s also raised the prospect of a potential downgrade after the October Medium Term Budget Policy Statement. Among hard currency bond markets, Lebanon had a disappointing month given the expectation of a rating cut by S&P and Fitch, with Fitch ultimately downgrading the bonds.
On the positive side, Egyptian assets once again continued to perform well. Inflation is low and encouraging and the central bank cut rates during the month which supported the currency and bonds.
Thailand’s local currency bonds also gained as the central bank surprised the market by cutting rates; the consensus expectation was for rates to be kept on hold.
We maintain our cautious view for the asset class in the near term and so we remain close to neutral overall, preferring to take active bottom-up relative value positions.
The growth outlook remains fragile across both developed and emerging markets. Trade risks continue to weigh on sentiment and it’s still unclear whether we will see any substantive progress between the US and China.
Given the short-term headwinds, we are positioned rather conservatively for now, despite the significant value we see in EM currencies (FX) on a long-term structural basis.
In local currency bonds, we believe risks are fairly balanced. On one hand, more accommodative monetary policy across emerging markets and globally provides a supportive backdrop; on the other, local yields have already rallied significantly.
Spreads in dollar debt markets weakened significantly in August, with high-yield significantly underperforming investment-grade bonds. We retain our overweight bias to high-yield markets, given current valuations – particularly in economies backed by IMF reform programmes.
*Keep an eye on our Emerging Perspectives page for forthcoming insights.
Past performance is not a reliable indicator of future results and all investments carry the risk of capital loss.
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The Asia credit market is a significant and growing part of the EM debt universe. With a low correlation to other major asset classes, it brings valuable diversification benefits to investors. And, as we explain in a new paper, we believe the increasing size and diversity of the region creates alpha opportunities from both country and security selection. However, distinct characteristics and a differentiated risk/return profile mean dedicated expertise is vital for capturing alpha and managing risk.
The dollar-denominated Asia corporate credit market has grown significantly in recent years, increasing its importance within the emerging market fixed income investment universe.
For emerging market corporate debt (EMCD) investors, Asia is an increasingly important region. It is the largest region in the popular JP Morgan Corporate EMBI Broad Diversified (CEMBI) Index, accounting for 37.1% of the overall index.1
The rise in the investable universe in Asia has been rapid, with most of the growth in issuance coming over the last decade. With approximately US$1.2 trillion outstanding, Asia credit is now four-times the size of the European high-yield market and similar in magnitude to the entire emerging market hard currency sovereign bond universe.1
The sheer size and diversity of the Asia corporate credit market are not the only features worthy of investor attention. We believe the market offers other compelling attractions for long-term, active investors.
In our paper, we consider Asia credit through the lens of our compelling forces framework, which covers:
Here’s a brief summary of our findings.
Asian companies’ credit fundamentals are typically healthier than their similarly rated peers’ in both emerging markets (EM) and developed markets (DM), and Asian firms are typically less indebted, making them more resilient to downturns.
Operating within relatively robust economies, Asian companies typically display better earnings growth. And it’s their desire to finance growth, diversify funding sources or lower funding costs – all factors that are beneficial to bond investors – that has driven growth in issuance.
A significant proportion of issuers are quasi-sovereigns which can often rely on government support. This typically benefits default risk and debt recovery relative to other markets.2
As is typical for EM vs. DM companies, Asian corporates offer a relatively attractive yield premium for their level of credit risk. Country-specific concerns often overshadow otherwise solid company fundamentals, pushing corporate bond yields higher than they should be. This translates to attractive valuations and, by extension, an attractive risk-reward profile for investors who are willing and able to carefully analyse the issuing company’s fundamentals.
Asia corporate credit may offer slightly lower credit spreads than its regional EM peers, but this is more than offset by a lower annualised volatility over the past decade.
The nature of ownership and stage of development of the Asia credit market give rise to compelling supply and demand dynamics:
1Source: JP Morgan, 31 July 2019.
2Source: Moody’s, 31 July 2019 (default rates); Moody’s, 31 December 2018 (recovery rates). See paper for more details.
3Over the past 10 years, Asia’s credit market has exhibited lower realised volatility than other regions, thereby offering attractive risk-adjusted returns (Source JP Morgan 30 June 2019).
The US-China relationship deteriorated with the US levying additional taxes earlier in August; China subsequently retaliated, as mentioned in our Market review above.
With China’s growth gliding lower, we believe the authorities may be tolerant of currency weakness. At the same time, we think they would prefer a stable currency backdrop, going into 1 October 2019, which marks the 70th anniversary of the founding of the People’s Republic of China, and ahead the next crucial round of trade talks with the US. Fundamentally, the renminbi is anchored by China’s robust overall balance of payments position; and unlike previous episodes, there have been very limited signs of domestic capital outflows this time round. We reduced our position in China’s renminbi by half in our benchmark-relative local currency strategies and closed our overweight in our blended strategies. In the latter, we express our still constructive view on China via dollar-denominated corporate bonds as we expect these to directly benefit from anchored credit conditions onshore.
In the Philippines, we initiated an overweight position in the peso, which we find attractively priced. We see less risk of domestic capital outflows owing to lower inflation and higher real rates. Additionally, remittance inflows have been steady and economy is less dependent on technology and exports. This puts the currency in a good place to outperform the other export-dependent economies in Asia, in our view.
In Indonesia, the trade deficit has been moderating and portfolio inflows look strong. Seeing limited catalyst for sustained weakness, we rotated our underweight in the Indonesian rupiah to the Indian rupee. India’s growth has disappointed and there is limited room for fiscal spending.
The theme in Latin America continued to be one of lacklustre growth and muted inflation. This backdrop generally pulled bond yields lower across the region, while currency performance was more mixed.
Politics continues to be the dominant driver of returns in the region: the market is now focused on what a Fernandez presidency might bring to Argentina in terms of policy and restructuring of debt (more on Argentina below), while in Brazil the focus has shifted towards the economy minister’s reform agenda and particularly, the prospects for tax reform. In Peru the government is trying to bring forward the election and in Chile the government seems gridlocked in Congress on its reform agenda. Lastly, in Mexico while the current president, Andrés Manuel López Obrador (‘AMLO’), continues to retain popular support, markets remain cognisant of risks relating to state-owned energy producer Pemex and wary of unorthodox policy.
Despite being below trend, growth in Colombia is stronger than in much of the rest of the region. The peso remains driven by global commodity prices and an uncomfortably high current account deficit, which have limited the central bank’s ability to lower rates further despite benign inflation. While we concur that the current account warrants caution over the longer term, we see short term value relative to its terms of trade.
In Brazil, the pension reform passed through Congress, and looks on course to pass through the Senate. Given this, the market is now looking to what further reforms Economy Minister Guedes can push through to help lift the country’s disappointing growth rate, with the focus now on the expected tax reform proposals due in the coming weeks. With inflation low and growth looking weak the bond market has now discounted a large amount of further monetary policy easing. However, the curve remains steep and real yields look attractive so we maintain a constructive view on the local bonds and currency. As mentioned in the Market review, environmental issues mean that trade and agricultural risks have risen so we are keeping a very close eye on developments there.
The shock result of the PASO (primary election) in Argentina fast forwarded the markets into discounting a Fernandez-Kirchner win in October. Asset prices collapsed, precipitating local bond maturity extensions, a debt reprofiling proposal and capital controls all in quick succession. The situation remains very fluid with the next IMF disbursement likely to be delayed and Fernandez, while not dismissive of Macri’s proposals, reluctant to endorse much before taking office. Markets remain under pressure and volatile. Given the uncertainty, we remain neutral the currency and underweight the local bonds. We continue to have exposure to hard currency bonds where we believe prices are excessively low given our expectations of a relatively market friendly debt reprofiling.
In Peru, bond yields continued to fall given low inflation, downwardly revised growth forecasts and the expectation of renewed easing by the central bank. We used the opportunity to trim our overweight bond position. The country’s politics is also becoming noisy as the president pushes to bring forward the next presidential and congressional election given the gridlock in Congress.
In Chile, weaker than expected growth and weakening terms of trade on the back of falling copper prices caused the peso to underperform, while pushing bond yields lower as the central bank continued to respond by aggressively cutting rates, pushing them to the lowest level in nine years. We cut our overweight position in the peso and moved back to neutral and remain neutral local bonds given the low yields.
In Mexico, weak growth and lower inflation allowed the central bank to ease rates. Although the central bank initially highlighted that this may not be the start of an easing cycle, rhetoric has since turned less hawkish and the market is pricing in further cuts quite aggressively. The market thinks the backdrop is likely to be conducive to further easing, despite the central bank’s concerns around financial stability, given AMLO’s unorthodox policy, vulnerabilities around state-owned energy producer Pemex , and trade concerns.
In Ghana, the government has started to look at renegotiating certain power purchase agreements (PPA) to deal with the take-or-pay issue it is currently facing.4 The government intends to complete this within the next three months. Some progress has been made to try to improve sustainability of the sector such as utilisation of domestic gas and reducing the use of take-or-pay agreements.
In Egypt, the central bank cut rates by 150 basis points to 14.25% in August, marking the start of the cutting cycle. A stronger pound as well as the continued fall in inflation supported the cut. We believe inflation will be under control and there could be further cuts this year. With the rally in yields, we are now starting to see increased speculation that Egypt may conduct single Euroclearable issuance at the beginning of 2020 while it works towards full Euroclear ability for debt stock later in the year.
In Kenya, all eyes are on newly appointed treasury secretary Ukur Yatani after the disappointing budget data released in August. Initial indications show that government agencies are headed for budget cuts and capital expenditure will focus on expanding space for public-private partnerships rather than taking any new projects directly onto the government balance sheet. The country’s current account continues to improve while inflation also falls to target. Full-year balance of payments data shows the current account deficit at US$3.8billion in 2018-19, down from US$4.8billion a year earlier. Kenya’s inflation fell to 5% year-on-year in August from 6.27% a month earlier, helped by falling food prices.
In Nigeria, the government was fined US$9 billion in the case between Process and Industrial Developments Limited and Federal Republic of Nigeria. This could open the door for more cases to be brought forward, with rumours already circulating on a specific potential case. The fiscal performance disappointed as both oil and non-oil revenues underperformed compared to the budget target. Growth also continues to disappoint, slowing to 1.9% year on year in Q2 2019, from a revised 2.1% year on year in Q1. Although oil GDP posted a healthy growth rate (rising 5.2% year on year from a contraction in Q1, likely driven by increased production), this was insufficient to fully offset weak non-oil GDP growth. Agriculture appears to have been a key factor dragging down non-oil GDP growth, despite an expansion in crop production.
In Zambia, the IMF released its Article IV, highlighting the need for significant frontloaded adjustment, but it was much less negative on the scale of adjustment or the need for debt restructuring than some might have feared. Meanwhile, S&P downgraded Zambia's long-term and short-term foreign and local currency credit ratings to CCC+/C from B-/B, citing the low foreign exchange reserves and rising external debt service obligations.
4 Take-or-pay clauses mean the government effectively pays for an agreed amount of energy supply regardless of whether it is used.
The release of second quarter GDP confirmed regional economic growth resilience up to mid-2019, with the pace of expansion stuck in the 3.5-4.0% range. Domestic demand remains the region’s key growth engine, although on the investment side there were signs of weakness. Growth risks remain skewed to the downside based on forward-looking activity indicators.
In Hungary, Q2 growth surpassed expectations and the full-year GDP growth rate could reach 4.8% in 2019. Labour market conditions remains tight, although wage growth slowed somewhat in the first half of the year. On the inflation front, although inflation peaked in May, June data undershot market expectations. We remain overweight local and hard currency debt.
In Poland, interest rate stabilisation remains the most likely scenario for the foreseeable future. Meanwhile, the uncertainty regarding the final Court of Justice of European Union (CJEU) ruling on the legality of the indexation clause in foreign-currency loan contracts put pressure on the currency as well as sparking significant underperformance among Polish banking stocks. We remain underweight Polish debt.
In the Czech Republic, domestic demand remains the key driver of GDP growth, in particular household consumption, which is still supported by real wage growth and government spending (reflecting a somewhat more supportive fiscal stance). However, forward-looking indicators and a further drop in German production are rather bad news for the future of Czech industry. We maintain our overweight position in Czech local debt. The Czech economy remains very sensitive to global trade dynamics and the Czech National Bank has ample space to ease monetary policy in case of a protracted and deepening global economic slowdown or an external shock such as a disorderly Brexit.
The National Bank of Romania maintained the key rate at 2.5%. The fiscal outlook remains the main idiosyncratic source of concern which prevents the NBR from joining other central banks in easing monetary policy. On the political front, leaders of the ruling party Alliance of Liberals and Democrats (ALDE) decided to break up the ruling alliance with the Social Democratic Party. Meanwhile, S&P affirmed Romania's credit ratings at BBB-/A-3, with a stable outlook. We maintain an overweight position in Romanian debt.
In Serbia, following rather weak growth data at the start of the year, economic activity picked up in the second quarter. Given that the economy is still growing at potential, amid a benign inflationary environment, we expect the National Bank of Serbia to maintain an accommodative stance. We maintain our overweight position in Serbian debt.
In other sovereign credit markets in the region, we increased our overweight exposure in Croatia while remaining invested in Georgia.
Turkish policy making and institutional quality weakened further over the month as the government removed nine high-ranking officials from the central bank (having already replaced the governor in the previous month). Those removed included the head of research who was extremely well-respected by the market, as well as the chief economist and head of banking regulation. Turkish bonds and the lira underperformed on the news before recovering some value into month end; we remain underweight both.
In the US, the White House announced its long-awaited Chemical and Biological Weapons sanctions selection on Russia. Included in its choice was the sanctioning of primary hard-currency sovereign bond issuance. After some initial nervousness in the market, Russian bonds performed better given this uncertainty had now passed. The ruble underperformed over the month, though, on seasonally weak balance of payments dynamics. We maintained our exposure to Russian assets given the country’s relatively strong economic fundamentals: we expect inflation to surprise to the downside, allowing the Central Bank of Russia to continue cutting rates, while the country continues to run a positive fiscal and current account balance.
Fiscal concerns continued to mount in South Africa on the back of a substantial increase in the bailout being offered to Eskom, the ailing state electricity provider, and a commensurate increase in the regular local bond issuance. However, the local bond curve remains extremely steep and had underperformed the market. We thus remain overweight local bonds and underweight the rand, a position which worked well over the month. We also remain underweight South African credit.
Ukrainian bonds performed poorly during the first half of the month as the market sold off. However, towards the end of the month we saw another significant tightening of spreads as the IMF announced that it would be making an official visit to the country in September and the president selected a market-friendly prime minister. We remain overweight Ukrainian credit and local bonds.
With geopolitical tensions easing to some degree in August, the main development in Middle-Eastern markets was the accelerating sell-off in Lebanese bonds. Yields on the country’s 2023 paper hit 16% by the end of August. The market backdrop post-Argentina was challenging for weaker credit markets, and with political deadlock over the summer pushing back both budget implementation and structural reforms, yields came under sustained pressure. This dovetailed with concern about Fitch and S&P ratings reviews (with Fitch ultimately downgrading the sovereign debt to CCC) and the impact on the banking sector’s regulatory capital. Despite this, there are some positives: cabinet has started to meet again and we expect some progress in the coming weeks on structural reforms and the 2020 budget. However, as it remains a very challenging position to gain conviction on, we remain uninvested.
In the rest of high-yield space in the region, we continue to hold Oman. We believe there is still value relative to similarly rated peers given the country’s sizeable sovereign wealth assets. Authorities have promised to release a medium-term fiscal plan by the end of 2019, and their use of asset sales this year and next helps moderate the debt trajectory. We retain our overweight in the long-end of Jordan’s debt market as the country remains committed to an extended IMF programme and the country’s external indicators continue to improve.
In the investment-grade space we retained our overweight exposure to Qatar where we see value given its low fiscal and external breakeven oil price and expenditure discipline. With Saudi Arabia’s long-end outperforming peers we exited our exposure to take profits.