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Emerging Perspectives

Our expert team examines the dynamic world of emerging market debt

Diverging inflationary trends: Helping unlock alpha opportunities

Peter Eerdmans, Co-Head of Emerging Market Fixed Income

For emerging markets (EMs), 2017 represented a year of disinflationary surprises. However, in recent months this trend has dissipated and if anything inflation began surprising more positively at the margin (see Figure 1). This supported our decision to stay fairly neutral on local currency bonds over the last few months.

Figure 1: Inflation surprises beginning to turn at the margins

GBI yield vs GBI inflation surprises

Source: Haver, Bloomberg, Investec Asset Management December 2017

We think overall inflation will likely see less downside momentum, although analysing the investment universe on a country-by-country basis tells a much more interesting story. Even in countries where inflation is likely to pick up, the reasons for the inflationary momentum are largely idiosyncratic, ranging from a combination of base effects, pass-through from oil prices, to excessively loose monetary policy and a reduction in spare capacity in some economies. At the same time, in some markets we expect disinflationary momentum in 2018, and risks for the asset class remain fairly benign with very few EM economies close to overheating. Thus from a bottom-up perspective, diverging inflationary trends are providing a constructive alpha generating environment.

Inflationary momentum turns modestly positive from cyclical lows

The rise in oil prices has led to some pass-through inflation in a number of net oil-importing countries. For example, Indian fuel inflation hit nearly 8% in November, the highest since 2013. Similarly, food inflation rose significantly, and core inflation has also started ticking modestly higher. This will likely force the Reserve Bank of India to commence an interest rate hiking cycle in the first few months of 2018, and therefore we prefer to play from the short side.

The pick-up in inflation also reflects the cyclical bounce beginning to reduce slack in some EM economies. In recent years, tight labour conditions failed to generate inflation in the Central and Eastern European (CEE) region, but this may finally be beginning to change. Czech growth may have only pushed up core inflation towards 2%, but this represents a multi-year high, and has encouraged the Czech National Bank to start its hiking cycle. This keeps us generally bearish on local bonds and rates, while we are more positive in FX. Hungary also experienced a surge in core inflation this year, although headline inflation will likely remain below target for 2018, and given the central bank’s commitment to flattening the yield curve we continue to like longer-maturing local bonds.

Inflationary pressure being met by a slow central bank response

In contrast to the Czech Republic, the Romanian central bank has been somewhat behind the curve, as our basic Taylor rule suggests (Figure 2), with inflation rising above target for the first time in four years. To date, the central bank’s attempts to control inflation by narrowing the interest rate corridor seem inadequate, with headline inflation surprising higher to 3.2% in November. This should finally encourage the central bank to raise interest rates in early 2018.

Figure 2: Romania Taylor rule suggests the central bank is behind the curve

Romania Finance-neutral Taylor rule: growth gap

Source: Haver, Bloomberg, Investec Asset Management December 2017 Taylor rule – This rule is an approximation tool used to estimate the responsiveness of nominal interest rates to changes in inflation, output, or other economic conditions

The lack of central bank credibility in Turkey has allowed core inflation (12%) and inflation expectations (9.3%) to hit 13-year highs. December’s rate tightening underwhelmed market expectations, and it’s likely that the FX pass-through from the weak lira will force the central bank into aggressively hiking rates in the early months of 2018.

Ebbing disinflationary momentum

Two markets in particular – Brazil and Russia – epitomised the disinflationary momentum over the last 18 months. Nevertheless central banks in both countries showed unprecedented restraint by only gradually lowering interest rates, therefore helping anchor inflationary expectations. This succeeded in both countries, with inflation rates moving from double digits in 2016 to below 3% now, and below or within their central bank’s targets. Naturally this trend is now beginning to slow and we should see a modest pick-up in inflation through the first half of 2018 (Figure 3).

We don’t find Brazilian local bonds particularly appealing at these levels. While we’ve been positive on Russia for most of 2017 we’re more bearish now, despite the central bank surprising markets with a dovish cut in December. We currently feel less optimistic for future interest rate cuts, with base effects creeping into inflation numbers and valuations looking somewhat stretched. Given the cyclical pick-up in economic growth and external account dynamics in both markets, we are more constructive on currencies than bonds for now.


Brazil headline CPI - dynamic PCA %yoy

Figure 3: Brazilian inflation nowcast

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

Markets where inflation can fall further in 2018

There are other markets, particularly in Latin America, where we still see material room for inflation to fall through the coming months. Argentina remains the most extreme example, with inflation still close to 25% and the central bank keeping rates very high to try and push down inflation expectations. While we think they will eventually manage to succeed in doing this, it will inevitably take time. Given the extent of the yield curve inversion, the risk reward pay-off is much more attractive in T-bills where we can still pick up a yield of close to 30%.

Chart 4: Argentine inflation nowcast points to disinflation through first half of 2018

Argentina San Luis CPI - dynamic PCA %yoy

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

Source: Haver, Bloomberg, Investec Asset Management calculations December 2017 Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.

In Mexico, Banxico retained its hawkish bias, delivering a cumulative 150 basis point hike this year in a bid to suppress inflation expectations. Our nowcast points to a tick down in inflation during the first half of this year and while longer-dated bonds may come under pressure from political news, we maintain a constructive view on the mid-part of the curve. We also remain constructive on Peruvian local bonds, due partly to our views on inflation. Lacklustre growth is having some downward pressure on pricing pressures, allowing the central bank to lower interest rates. Outside of Latin America, South Africa represents another market which should experience some disinflationary momentum this year, which we expect the central bank to recognise by cutting rates during the first quarter of this year. This, combined with the market pleasing ANC election outcome, keeps us positive on the country’s bonds going into 2018.

 

Emerging market elections; market-pleasing results in three countries

Peter Eerdmans, Co-Head of Emerging Market Fixed Income

As we have mentioned before, emerging markets (EMs) are at the start of a busy election calendar over the next 12-18 months. Election outcomes can be crucial in driving policy direction and therefore asset prices. This past weekend we had the first three of these EM elections, and all resulted in the more market friendly outcome. In the case of South Africa, this wasn’t straightforward but Ramaphosa’s victory represents a transformational moment for this young democracy and its people.

Modi passes local election test

Let’s start with the least market-moving election, the local elections in two Indian states, Gujarat and Himachal Pradesh. While of limited economic impact, the elections were an important litmus test of Prime Minister Modi’s popularity and reform agenda, particularly important given the next general election is less than 18 months away. It was an encouraging victory for this party, which secured majorities in both states. Admittedly the size of the majority in Gujarat was a bit disappointing, although the BJP recorded a better than expected result in Himachal Pradesh. Overall we see the result as a positive one for the BJP, with the current trajectory of reforms likely to stay in place.

Pinera returns to the helm in Chile

Meanwhile in Chile, pro-business ex-President Sebastien Pinera was elected after the second round of the Presidential Election. After a tighter than expected first round (which spooked the markets), Pinera easily defeated the leftist Guillier, with a projected 55% share of the vote. During four years of Bachelet, the reform agenda stalled and more populist policies were adopted. Thus the business-friendly Pinera should ensure a more pro-reform agenda in the coming years. This resulted in the Chilean peso being one of the strongest EM currencies this month, up 4.5% (at the time of writing). We remain constructive on Chile and believe we can see positive reforms, improved business sentiment and a pick-up in growth after a few disappointing years.

Ramaphosa’s victory brings new hope for South Africa

The most hotly contested and arguably most important election this weekend was not a public one, but the internal election for the ANC Presidency. The election polarised the ANC and indeed the country with Nkosazana Dlamini Zuma (NDZ) representing the under-fire Zuma faction, which is accused of blatant corruption and weak economic and fiscal policies, versus the more market-friendly candidate Cyril Ramaphosa. The policy differences between the two candidates meant the market viewed the outcome as binary, with a Ramaphosa win representing a return to the days of prudent macro policy and a NDZ victory symbolising a continuation of institutional decline.

As the market gained greater confidence of Ramaphosa’s victory, the rand rallied (by over 6% this month at the time of writing). Ultimately, internal divisions meant that a compromise result was inevitable. As such, despite Mr Ramaphosa taking the ANC presidency (and likely South Africa’s presidency in the next national election) the top-6 party positions were split 3-3 across the factions, with at least two deeply compromised people (David Mabuza and Ace Magashule) taking senior positions. This highlights the need for caution, and clearly we also need to see how quickly Ramaphosa’s victory translates into better policy as he balances the demands of both the nation and the ANC itself. But overall, this result is a positive for South Africa’s future.

All in all, these three results were encouraging. This may well set the scene for further positive outcomes in the busy 2018 election cycle. This combined with a strong economic growth outlook and relatively attractive valuations, should bode well for Emerging Market Debt returns in the New Year.

 

ANC Elective Conference

Nazmeera Moola, Co-head of SA & Africa Fixed Income

Ramaphosa win sees short-term rally but divided top 6 will make progress difficult

In a remarkably close election, Cyril Ramaphosa became the new President of the ANC, beating out Nkosazana Dlamini-Zuma by 179 votes. While the rand, equity markets and the local South African bond market rallied ahead of the election, the currency retraced some of its gains when the announcement was made. The rally looks to be done for now. For further positive momentum, concrete signs of progress are needed.

This will not be easy. Part of the reason for that will be the deeply divided top 6 of the ANC. The top 6 are evenly split between three members of the Ramaphosa slate (President: Cyril Ramaphosa, Chairman: Gwede Mantashe and Treasurer-General: Paul Mashatile) and three members of the Dlamini-Zuma slate (Deputy President: David Mabuza, Secretary-General: Ace Magashule and Deputy Secretary-General: Jessie Duarte).

After a decade of sub-par growth and excessive government spending, South Africa needs growth to rebound to 2.5% in the coming year to stabilise the debt-to-GDP ratio in the next three years. This stable debt profile is needed for South Africa to hang onto the Moody’s investment grade local currency rating.

The pick-up in growth is only possible if consumer confidence returns followed by business confidence. Household cash balances at commercial banks as a percentage of GDP have risen sharply in recent years, and are currently 3.5 percentage points of GDP above the long-term average. This translates into roughly R160bn extra sitting in cash or cash-like instruments that could be spent.

If consumers enter 2018 feeling more optimistic, this is certainly possible. However, any spending buoyancy will be offset by tax hikes, with limited relief for inflation and potentially VAT on fuel and property rates. Therefore a significant boost to confidence is required to overcome this. A change in the President of South Africa in early 2018 could go a long way towards generating such confidence.

Beyond the consumer, corporates need to start investing. The relationship between business and Cyril Ramaphosa is far stronger than it was between business and Jacob Zuma. This has often been used as a criticism against Ramaphosa in the ANC leadership race. However, this should turn from a hindrance to a help in 2018, as the higher degree of trust encourages business to start thinking about investing.

In order to realise a long-term boost to investment, the regulatory environment needs to improve. Policy uncertainty has been a key reason for the lack of investment. For example, mining volumes have contracted in South Africa through 2017 – despite the pick-up in commodity prices. Mining companies are not investing and a good portion of the blame is the disastrous process around the Mining Charter. There are several other examples such as this.

The concern around the divided top 6 is that the ability and commitment to implement such measures will be limited. The composition of the 80-person National Executive Committee (NEC) of the ANC, which will be elected by the end of the conference on 20 December, is therefore key. A cleaner NEC that encourages President Jacob Zuma to step aside earlier would help lay the platform for a boost to consumer confidence in the first instance and then business confidence. The election of Cyril Ramaphosa is undoubtedly good news for financial markets. Nonetheless, given the split in the top 6, the composition of the NEC will be key to determining the durability of the rally through 2018.

 

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Once unthinkable policy progress being made across the Southern Cone

Mike Hugman, Portfolio Manager

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

ARGENTINA:

Politics:

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

Macro fundamentals:

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

Figures below showing: Argentine growth looks set to remain solid, aiding the fiscal adjustment but keeping the current account deficit wide and inflation reasonably high


Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017
Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.


Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017



Source: Haver, Bloomberg, National Statistics and Censuses Institute, IAM calculations November 2017

ESG:

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

INVESTMENT IMPLICATIONS:

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

RISKS:

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

URUGUAY

Politics:

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

Macro fundamentals:

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

ESG:

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

INVESTMENT IMPLICATIONS:

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

RISKS:

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

CHILE

Politics:

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

Macro fundamentals:

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

Figures below showing: That despite the short-term political risk, external balances in Chile are improving as shown in the nowcast, while inflation risks remain reasonably contained


Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017 Nowcasting: Econometric modelling is inherently imperfect and not a reliable indicator of future results. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.


Source: Haver, Bloomberg, National Institute of Statistics, IAM calculations November 2017



Source: Haver, Bloomberg, Banco Central de Chile, IAM calculations November 2017

ESG:

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

INVESTMENT IMPLICATIONS:

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

RISKS:

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

1Peronism – is a brand of populist and nationalistic politics that has a history dating back to the mid-1940s in Argentina.
2As at November 2017.
3PPPs often involve a contract between a public sector authority and a private party.

 

Africa's rising debt: Looking beyond the headlines

Thys Louw, Assistant Portfolio Manager

While rising African debt levels occupy headlines1, we sift fact from fiction below, and discuss how we evaluate opportunities. Read more by downloading the full Viewpoint here.

Are we close to a tipping point? 

Debt dynamics across the region, defined here as median gross government debt to GDP, have gone through three main cycles over the past 20 years:

1996-2005: Large scale debt relief

Following a sharp rise in indebtedness in the 1990s, the early part of the 2000’s was a period of debt consolidation and write-offs in Africa as a result of the Heavily Indebted Poor Countries (HIPC)2 programme and its replacement, the Multilateral Debt Relief Initiative (MDRI)3.

2006-2014: Africa Rising 

 After a sustained period of consolidation, with median debt to GDP hitting a low of 38.1% in 2008, the exponential rise in commodity prices helped stimulate growth and investment into Africa. African governments borrowed in international markets to support investment expenditure – but as deficits worsened, risk rose.

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

As oil prices collapsed from June 2014, accompanied by rising borrowing costs, balance sheets deteriorated. However, re-leveraging across Africa and other frontier markets (Chart 1 below) hasn’t been at the expense of debt balances, given growth.

Chart 1 – Regional Emerging Market Gross Government Debt as a % of GDP

Source: IMF WEO, IAM Calculations October 2017

Where to from here? 

The African region is expected to deleverage from now until 2022, reflecting stabilisation in commodity prices, improvement in global growth and economic reforms that were implemented during the crisis.  

While the build-up of African debt balances is a risk, balance sheets should stabilise below distressed levels, providing the external environment remains stable. 

With 54 countries across the region, we recognise that Africa represents a diverse investment universe; real value can be added by understanding divergences within Africa, and acting on these insights through active country allocations. So how do we differentiate?

Risks and Opportunities within Africa

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

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

Implications for positioning

The dispersion of economic fortunes across Africa represents opportunity for the discriminating. We continue to favour reforming countries and reflect this in the portfolio through positions in Egypt, Nigeria, Morocco and Zambia, where permitted. We also selectively allocate to countries such as the Ivory Coast and Uganda given their manageable debt metrics and attractive growth rates. Looking beyond the negative headlines, the period ahead still looks promising and we will continue to keep you updated on interesting trends across the continent.

 


 

1 Most prominently through the Financial Times’ article titled ‘African debt worries intensify as levels near tipping point’ (click here).

2 Is a group of 39 developing countries (33 of which are in Africa) which qualify for debt relief and low interest rate loans from the IMF and World Bank, where debts are considered unsustainable (defined as debt to exports>200-250% or when debt to government revenues exceeded 280%). Initially launched in 1996 it has provided full or partial debt relief to 36 countries.

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

 


Venezuela: Still walking on a tightrope

Vivienne Taberer, Portfolio Manager

Brief update on Venezuela:

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

Positioning

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

 


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

Roger Mark, Product Specialist

A silver lining of the Trump administration’s protectionist agenda has been that emerging market (EM) governments have, on the whole, reaffirmed their commitment to freer trade. Reassuringly, they recognise the positive influence of open markets in driving EM economic growth over the last three decades.

While Trump stole much of the headlines from the APEC meeting over the weekend, 11 countries (including Malaysia, Chile and Peru) finally agreed to push ahead with a revised version of the Trans Pacific Partnership (TPP)*. This strongly signalled remaining participants’ commitment to trade liberalisation, despite Trump withdrawing from the agreement during his first day in office. Even without US involvement, the scale of the prospective agreement is significant – 500 million people and over US$10 trillion in aggregate GDP. That said, without US involvement, the economic gains are more modest. A recent paper from the Peterson Institute for International Economics (PIIE) highlighted the economic benefits of TPP (ex-US) would be limited to approximately US$150 billion, or less than half the benefits of the agreement with US participation. However, if the five other Asian countries that have shown an interest in the agreement were to join then the economic benefits would approach those of the original TPP according to the PIEE analysis.

Unfortunate delay in RCEP agreement, although deal still likely

Also at the weekend was a modestly disappointing delay to the other large putative Asia-centric trade agreement, the Regional Comprehensive Economic Partnership (RCEP)**. A ministerial meeting at the side-lines of the Asean summit in Manilla decided to push back the timeline till 2018 (there had been hopes it could be signed this year).

A trade deal does, however, still seem very likely. RCEP is regarded as a lower quality trade agreement than TPP (limited coverage of services & investment, and weaker labour and environmental provisions), however it covers a much larger GDP base (4 of 10 largest global economies are in RCEP). PIIE estimate global income gains of around US$300 billion and the economic benefits could be significantly higher if countries like Japan and Australia manage to succeed in getting some services provisions into the agreement. Moreover, both agreements can facilitate a framework for further rounds of gradual trade liberalisation (possibly with US involvement under a more receptive administration).

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

Admittedly both trade agreements have a long way to go, although the progress to date shows that the world is moving ahead with trade liberalisation despite the US flirting with protectionism. This should help to underpin global trade growth over time. As Chart 1 shows, the rate of trade expansion has been lacklustre since the financial crisis – partly reflecting cyclical factors like the sluggish pace of global economic growth, but also structural factors such as the shortening of global supply chains (particularly in China).

The stalling of the Doha round of global trade negotiations and lack of progress on regional trade agreements has also likely played a significant role in the trade slowdown. Indeed, just a year ago, considerable gloom existed among trade economists. Now, fresh progress on trade agreements, driven in part by emerging markets, could help to underpin a longer-term re-acceleration in trade growth (which has already started to pick-up somewhat with the cyclical upswing in global economic activity). Thus, while there are significant concerns around the future of Nafta and Korea-US Free trade agreement, clearly the US administration is not going to be able to reverse the long-run trend towards greater trade liberalisation, and that EM governments recognise the importance of open trade for their economies. 

Chart 1: Global trade volume growth (year-on-year %)


Source: Investec Asset Management, CPB Trade Monitor, November 2017


*TPP members: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam.
**RCEP members: 10 ASEAN countries + Australia, China, India, Japan, South Korea and New Zealand.

 


Venezuela - 'Refinancing or restructuring'

Vivienne Taberer, Portfolio Manager

What we know:

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

Impact on bonds:

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

Our strategy from here:

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

 


Xi embeds his power and reaffirms policy direction

Mark Evans, Analyst, Emerging Market Fixed Income

The nineteenth National Congress of the Chinese Communist Party (the Party) was held from 18 - 24 October, followed by the First Plenary session today (25 October). As expected, President Xi cemented his status as the “Core Leader” of the Party; with “Xi Jinping Thought” having been enshrined into the Constitution. Furthermore, no obvious successor exists within the newly formed Politburo Standing Committee, increasing Xi’s chances of serving past his expected retirement in 2022. Consequently, the significance of other personnel changes was diluted, but from our perspective there will be little to distract President Xi from his policy agenda for the remainder of his term.

At the beginning of the National Congress, Xi’s Work Report laid out the broad plans for the next 30 years. Nevertheless, the market will focus most heavily on what to expect over the next 12 months. In terms of policy direction and momentum, we don’t expect much of a change over the short-to-medium term.

Firstly, Xi has long been considered the most powerful president for decades, so the last week has essentially rubber stamped a process which has been evolving over the last five years and was already well understood. Secondly, and somewhat related, we have seen an impressive shift in the gears of policy implementation over the last 18 months, with a clear focus on better supply side management. This contrasted with previous years where too much emphasis was placed on boosting demand through aggressive credit growth. As a result, the need for drastic policy change is limited at this stage. We therefore expect a continued focus on deleveraging, reducing excess capacity and pollution through SOE shutdowns and tightening controls on the property market to contain overheating risks.

From a portfolio perspective, we remain constructive on the Chinese renminbi. The balance of payments is in surplus as capital outflow pressures have eased significantly. Nevertheless, we still see some evidence of disguised capital outflows and hence do not expect any imminent capital account liberalisation. Trump’s visit to China next month comes as the trade balance between the two countries continues to widen, therefore ongoing currency stability or mild strength will be in China’s best interests.

 

 


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

Peter Eerdmans , Co-Head of Emerging Market Fixed Income

It’s been a fantastic run for local currency emerging market debt (EMD) this year – up around 15% (in US dollars)1 and on track for its best return since 2009. Despite the strong rally, we believe that at a time of stretched valuations across other capital markets, local currency EMD is one of the few global asset classes offering genuine value. Both elements of local currency bond returns – yield and FX – appear to have room to appreciate further from current levels, particularly in high yielding markets.

If we turn to yields first, the GBI-EM weighted index yield is hovering around 6% at present. This remains relatively high compared to history, but on a real (inflation adjusted) basis valuations look even more attractive. The below table highlights the scale of disinflation across some of our key markets.

Across many EMs inflation is now at record lows

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

 

Source: Bloomberg, 30 September 2017

Pleasingly, monetary authorities have shown unprecedented discipline when reducing interest rates – a function of the increasing independence of EM central banks and their adoption of explicit inflation-targeting regimes (in countries as diverse as Argentina and Ukraine). While some central banks began easing monetary policy to support their economies – particularly in recession-hit countries like Russia and Brazil – they have done so in a largely credible fashion, ensuring inflation expectations remain anchored.

Consequently, interest rate reductions have generally been quite modest which has helped keep real interest rates and local bond yields high versus history. This relationship appears particularly noticeable when we compare the real yield between high and low yielding EM bond markets, as can be seen in Chart 1. In the high yield space, real yields remain close to their highs. With structurally lower inflation being sustained by credible central bank policy, nominal yields should continue falling outside of any external shock. By contrast, low yielding bond valuations look closer to fair value, although they don’t look exorbitantly expensive relative to history.

Chart 1: GBI-EM real bond yields across high and low yielding markets


Source: Haver, Bloomberg and IAM September 2017

Chart 2: EM real yield differential over developed markets remains elevated, and above its historic average


Source: Source: Haver, Bloomberg and IAM September 2017

This real yield buffer should continue to support foreign inflows, especially considering the attractiveness of EM currency valuations. On a nominal effective exchange rate basis 3, EMFX performance this year has been lacklustre given the strength of the euro. Similarly, using the real effective exchange rate (REER) method4, EMFX also looks inexpensive compared to history, particularly high yielding EMFX5. Even after accounting for the changed macro environment, we believe EM REERs for a number of high yield currencies remain 5-10% below fair value.

Chart 3: ELMI weighted REER high yield vs low yielding currencies


Source: Haver, Bloomberg, JPMorgan and IAM September 2017

The robust growth outlook across emerging markets should support further REER appreciation over the next few months, as we are still at a relatively early stage in this cyclical pick-up. As well as positive bond flows, equity flows should also be supportive given positioning remains light (indeed there has been net selling in recent months) and the fundamentals are improving, with net income margins rising, and as Chart 4 highlights, forward price-to-earnings (P/E) ratios6 still attractive relative to history and developed markets.

Chart 4: Developed vs emerging market equity valuations using P/E ratios


Source: Haver, Bloomberg and IAM September 2017

Thus we see fundamentals, valuations and positioning all still lining up positively to support local currency EMD over the medium term. With several emerging market economies also set to benefit from an increased stock of capital, technological progress and pro-market structural reforms this allocation argument is only strengthened.

1 As at 30 September 2017
2 Year-on-year change in the index
3 The weighted average rate at which one country’s currency exchanges for a basket of other currencies, not adjusted for inflation
4 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation
5 FX valuations need to be framed within the context of the end of the commodities super cycle, which drove the structural break in EM growth to a more sustainable, but lower rate, as well as driving the deterioration in in commodity terms of trade
6 The forward price-to-earnings ratio is a company’s current stock price divided by its estimated earnings per share

 

 


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

Thys Louw, Assistant Portfolio Manager

Falling oil prices, an import-dependent economy and multiple policy mistakes by authorities almost tipped Nigeria into depression. Over the last two years we have had little-to-no exposure to Nigeria on the back of our pessimistic view of Nigerian economic policymaking in an environment of lower oil prices. This strategy has not only saved our clients from significant losses, but also ensured that our EMD strategies faced no repatriation risks due to significant shortages of US dollars. However, in our view, an opportunity is beginning to open up and we are re-allocating to a country with improving economic fundamentals, more sensible economic policy settings and one which is priced attractively.

Consequences of bad economic management:

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

Where are we now?

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

How are we capitalising on this opportunity?

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

 

 


Argentina primaries: A promising, market-friendly result

Vivienne Taberer, Portfolio Manager

The casual observer could be forgiven for thinking a real election just took place in Argentina. It was, however, just a primary – the elections only take place on 22nd October. But primaries in Argentina are quite unique – all parties take part in the same vote. Thus it provides an important gauge of the political climate in the country – the first true indication since Macri’s election victory in 2015. And the results were a positive surprise for him and investors. Give market weakness over the last few weeks, the result precipitated a strong rally in Argentine assets with the peso rallying 3% on the news and dollar spreads closing 40bps tighter as the market.

Populist ex-president Kirchner underwhelmed:

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

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

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

What next?

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

Current investment views:

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

 

 


Barriers for entry slowly collapsing in Chinese bonds

Wilfred Wee, Portfolio Manager

Accessing China’s interbank bond market is set to become significantly easier following the implementation of China Hong Kong Bond Connect (CHKBC) in July 2017. CHKBC forms a direct, efficient and transparent platform for offshore institutional investors to access the mainland’s debt market, and will almost certainly be the preferred bond market route for new investors. In our view, CHKBC will inevitably speed up the timing of China’s index inclusion and enable a constant flow of capital from international investors. The Chinese bond market remains a compelling investment opportunity given its yield and diversification benefits, and with operational barriers being broken down further this argument is only strengthened.

What’s changed?

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

Our core EMD funds already have the flexibility to trade in China through either RQFII or CIBM direct. However, given the increased flexibility of CHKBC we can use this method for any future funds or segregated portfolios which have not yet had access to the Chinese bond market.

 

 

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