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Emerging Perspectives

Our expert team examines the dynamic world of emerging market debt

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.

 

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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.

 

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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.

 

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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.

 

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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.

 

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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.

 

 

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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

 

 

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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.

 

 

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Past performance is not a reliable indicator of future results and all investments carry the risk of capital loss.

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