Emerging market (EM) fixed income continued to strengthen in July. Both the hard currency and local currency bond markets rose, thanks to the expectation of an interest rate cut by the US Federal Reserve. Among sovereign bonds, hard currency outperformed local currency: the JPMorgan EMBI (hard currency index) rose by 1.2% while the JPMorgan GBI-EM Global Diversified index (local) rose by 0.9%. The main corporate bond index (JPMorgan CEMBI) also rose by 0.9%.
July was relatively quiet on the trade war-front. A tweet announcing tariffs has since escalated matters, but it came after markets had rounded off a solid month.
Turkish local currency bonds and the lira performed well, benefiting from an upbeat inflation report from the new central bank governor, which resulted in a cut in interest rates. This helped some market participants to overlook concerns about the central bank’s independence, sparked by Erdogan’s government dismissing the previous governor.
Brazilian local bonds and the real also ended strongly after the pension reform bill passed the first round of votes in the lower house of Congress. Although this was largely anticipated, it has reduced uncertainty and is expected to lead to a rebound in growth and a renewed easing cycle.
Egyptian assets continued to strengthen, with the country’s economic progress and the relatively high yield offered by its currency continuing to attract investors.
Among hard currency sovereign bonds, Zambian bond yields fell as the president appointed an experienced and credible new finance minister, boosting investor sentiment over the country's growth and inflation outlook.A few markets that did not join the wider rally included South Korea, where ongoing trade uncertainty – including tensions with Japan – weighed on asset prices.
South African bonds had a disappointing month as increased concerns relating to the struggling state-owned utility firm Eskom led to rating agency Fitch changing the country’s outlook to negative. Moody’s also expressed concerns that risks surrounding Eskom's bailout could be high.
We have turned more cautious on the near-term outlook for the asset class. Concerns about global growth have resurfaced, with global economic data continuing to disappoint and the latest developments in the US-China trade dispute likely to weigh further on global demand. This is at least partly offset by US Federal Reserve-led easing of global monetary policy.
From a top-down perspective, we have turned closer to neutral overall.
In local debt, we are neutral bonds – nominal yields have tightened significantly, though they will be supported by further Fed and EM central bank easing.
We have turned slightly defensive on FX – with the global growth environment looking subdued it is hard to see near-term EM currency strength.
With Treasury yields still expected to grind lower and spreads offering some value, we currently prefer hard currency debt.
*Keep an eye on our Emerging Perspectives page for forthcoming insights.
Investments carry a risk of capital loss.
This material is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual results may differ materially from those stated herein. All rights reserved. Issued by Investec Asset Management, issued August 2019.
The July lull in markets we mentioned in our market review proved short-lived, and not just because of President Trump’s tweet on trade tariffs. A primary election result in Argentina came as a negative surprise to investors. Mike and Vivienne discuss its implications.
In Argentina’s primary election, voters made clear their frustration with the fragile economic conditions and high inflation they have experienced under President Macri’s government. In contrast, the opposition party’s populist rhetoric clearly paid off and it now seems likely that Alberto Fernandez will beat Macri in the presidential election.
Voters have lived through some tough recent times. Global market pressure, combined with the real-economy shock of a drought, led to a series of large devaluations of the exchange rate in 2018, forcing Argentina to take an historic US$56 billion IMF programme and taking headline inflation to over 50% year on year. The significant fiscal and monetary adjustment required to stabilise the situation had its desired effect in reducing the current account deficit and closing the primary deficit, but triggered a material recession. Fueled by promises from a populist opposition party, voters’ patience has clearly run out.
Recent statements from Alberto Fernandez have been mixed, leaving the market uncertain as to future policy direction and how market friendly it will be. While Fernandez has stated that he aims to adhere to IMF lending terms, suggesting a new government would look to avoid a confrontation with bondholders, we believe market developments may force one.
Our analysis indicates that Fernandez’s planned policy of a weaker Argentine peso (ARS) will likely make the debt stock unsustainable. About four-fifths of Argentina’s debt stock, which represents approximately 80% of GDP, is in hard currency. Hence a move to, say, 60/1 in the ARS/USD exchange rate (from about 45/1 pre-election) would put Argentina’s debt/GDP ratio on an unsustainable path.
A further challenge for foreign bondholders is that around half of the sovereign debt stock is owned by the IMF, the Argentine central bank and ANSES (the national pension fund). Thus, a restructuring would apply only to around 50% of the total debt stock, likely requiring a much higher haircut than would otherwise be the case. If a Fernandez government implemented its proposed policies, we estimate a 50% haircut would eventually be required on tradable debt to make the debt stock sustainable.
While at the time of writing the initial surge weaker on the peso had been contained, further volatility and weakness seems inevitable into the transition to a new administration, given expected local outflows and relatively heavy offshore positioning. That said the Argentine central bank has some room to intervene in FX futures markets under the current IMF framework. We expect that it will look to stabilise the ARS/USD rate into the election, to try to engineer a less disorderly political handover, although it can ill-afford to significantly deplete reserves.
For now, the government has sufficient reserves and IMF funding to make it through to the end of 2020 (assuming it is able to adhere to IMF lending terms), so we estimate another 1.5 years of coupon payments could be made.
There is a risk that panic about the potential for capital controls sparks a capital flight that makes the imposition of such controls self-fulfilling. Hence, we believe there are higher risks associated with local currency bonds and local-law US dollar-denominated debt, which could be caught up in capital controls.
While Alberto Fernandez believes a weaker exchange rate will promote growth, he has been clear he wants to avoid broad capital controls. He also wants to promote foreign direct investment, especially into the Vaca Muerta oil fields and the agricultural sector.
Earlier this year we took the view that it was hard to call any election outcome beyond 50/50 and looked to take a conservative position, moving close to neutral in our benchmark-relative portfolios. In contrast, our main data sources* show that Argentine US dollar debt and the ARS are among the largest overweights held by active emerging market debt (EMD) managers, on average.
The summer has left investors with much to digest and events in Argentina have proved that investing in emerging market debt requires constant vigilance and agility.
* Trounceflow, Bank of America Merrill Lynch, JP Morgan.
The US Trade Negotiation team flew to China for the first round of talks since the trade war escalated in May. Both sides noted that the discussions were constructive, suggesting that the situation had at least stabilised. This created a calm backdrop in July. While the US proposal at the start of August to implement 10% tariffs on US$300 billion of imports from China was a big surprise and caused the renminbi to weaken, we believe the Chinese authorities would prefer a fairly stable renminbi, and hence we retain our overweight versus peers.
We believe that the more open and smaller economies in Asia will ultimately suffer a larger impact as a result of the escalation of trade tension. Therefore, we retain our underweight positions in Malaysia and Taiwan. We have recently increased our underweight in Korea to reflect the deterioration in the trade negotiations and Japan’s recent decision to tighten export rules has added further pressure on the Korean won.
Thailand's solid current account position continues to underpin strong performance in the Thai baht. While the central bank has become more concerned about currency strength, we believe there is little it can do to lean against the fundamentals. We remained underweight duration in Thailand against other preferred long positions in the region.
In Malaysia, inflation normalised higher as base effects of cuts in goods and sales tax (GST) in June 2018 started to roll away. With the overhang of potential index exclusion, we remained underweight bonds and the currency.
Indonesia's second quarter GDP glided lower, dragged by lower investments and exports but lifted by resilient domestic consumption. With domestic growth and inflation moderate and real rates attractive, we moved to an overweight positioning in the bonds. Given relatively heavy positioning and rich valuations, we currency hedged the bond position and stayed underweight the currency.
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 play an outsized role in the region: the market continued to fret about the election in Argentina (see Insights from the team); the social security reform passed the first congressional hurdle in Brazil (more below); and the governments of both Peru and Chile pushed to pass their reforms. In Mexico while current President AMLO continues to retain popular support, markets are watching developments on trade and PEMEX closely.
Despite being lower than trend, growth in Colombia is stronger than in much of the rest of the region. However, this has led to a widening current account deficit, which has kept the peso under pressure and interest rates on hold.
In Brazil, the passage of the pension security reform through the first vote in Congress has opened the way for the central bank to resume easing rates in response to weak growth and low inflation. This has allowed the Brazilian yield curve to bull steepen (short-term rates falling faster than long-term rates leading to higher spread between the two).
In Peru, as bond yields continued to fall on 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.
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 remained dovish and the market priced in further easing.
In Mexico, weak growth and lower inflation mean the market continues to price in easing by the central bank despite concerns around PEMEX, the unorthodox policies of AMLO and the resignation of finance minister Urzua.
In July we received the much-anticipated mid-year budget review in Ghana. The budget remained light on planned revenue proposals but did include a much more realistic deficit expectation and also took issues related to the banking and energy sectors in detail. On balance this budget provides some comfort that, although spending pressures might be high as we head into the election, the government remains committed to staying within the 5% target deficit mandated under fiscal responsibility rules.
The central bank of Egypt kept rates on hold even as inflation measures collapsed. This reinforces the message that the central bank will be very measured in its easing process and should support flows into the local market given the monetary policy easing happening globally.
Senegal has continued to try and get to grips with the fallout from the BBC Panaroma expose which placed the president’s brother at centre of what was claimed to be overly generous private sector oil contracts. We see the risk of significant credit impact from this as limited and remain positive on the development of oil sector in Senegal.
In Zambia, President Lungu replaced Minister of Finance Margaret Mwanakatwe with Bwalya Ng’andu as the government tries to deal with the domestic and international fallout over pressure to deal with the growing fiscal and debt burden. Although the road to recovery remains narrow we are encouraged that the government seems to be taking fiscal issues more seriously.
The Ugandan shilling was supported over the month by changes to the withholding tax (cut from 20% to 10%) which encouraged foreign inflows into the bond market. This change was prompted by the government's need to support much larger fiscal deficit plans. We remain negative on the shilling given the deterioration in fiscal and current account deficits and now higher foreign positioning.
In a surprise move, Kenya's Treasury Secretary Henry Rotich was fired in July due to corruption charges related to infrastructure procurement contracts. Although there could be some political fallout from the move we see Kenya’s move to deal with corruption in a more direct fashion as a positive signal.
We believe the resilience of Central European economies to the slowdown in the Euro area has been remarkable, considering the cross-border integration in manufacturing through ownership, trade, and financial links. Domestic demand in the region remains strong supported by tight labour markets and relatively easy fiscal policies. Overall, even though activity held up well to mid-2019, risks are now skewed to the downside.
In Hungary, the underlying inflation measures of the National Bank of Hungary decelerated sharply in July, in line with NBH expectations. On the activity front, calendar-adjusted industrial output remains in positive territory but slowed down visibly. Hungarian bonds performed strongly while the Hungarian currency depreciated further. We remain overweight in local and hard currency debt.
In Poland, inflation accelerated further in July with food prices coming as the strongest contributor. Core inflation keeps rising but is unlikely to change National Bank of Poland's (NBP) cautious stance which is focused on the uncertain economic outlook. We remain underweight Polish debt.
In the Czech Republic, the Czech National Bank (CNB) board voted unanimously to keep interest rates unchanged at its latest meeting considering the economic outlook is slightly anti-inflationary. Meanwhile, the manufacturing PMI slumped yet again, down to its lowest in a decade. The unemployment rate also reached a record low and retail sales grew faster than expected. We maintain our overweight position in Czech local debt.
In Romania, the National Bank of Romania (NBR) kept the policy rate unchanged at 2.5% reiterating its commitment to strict liquidity control measures being enough to restrain inflationary pressures. The finance ministry published its general government budget revision proposal, with upward adjustments of both revenue and expenditure resulting to a budget deficit for 2019 of 2.76%. Fiscal council, however, concluded that there are still significant risks on general budget to exceed 3% of GDP and called for additional spending cuts. We moved to a moderate overweight position in Romanian debt.
The National Bank of Serbia surprised markets again by cutting the key policy rate by another 25bps to 2.5%, in a move aimed to support lending and economic growth. The central bank delivered a similar cut last month. The rate cut decision comes amid low inflation and slowing economic growth, the latter of which could surprise on the downside. We maintain our overweight position in Serbian debt.
In other sovereign credit markets in the region, we maintain our overweight exposure in our high conviction markets including Croatia and Georgia.
We maintained our underweight position in Turkish local bonds where yields had rallied, and the yield curve became very inverted. Geopolitical risks also ran high with the government insisting on taking delivery of a Russian-made S-400 missile system in the face of US sanctions threats. Despite this and the forced replacement of the central bank governor which further eroded central bank independence, Turkish bonds rallied strongly in anticipation of aggressive interest rate cuts.
We continue to be overweight Russia. The central bank cut rates by 0.25% for a second time in the face of falling inflation and lacklustre growth. We remain encouraged by the long-term fundamental outlook for this economy and especially inflation.
South African assets performed poorly over the month as the country’s economic data continued to disappoint and the problems at Eskom, the state utility, continued to mount. The central bank cut rates by 0.25% during the month, as largely expected. We had shifted to an overweight positioning in local bonds in anticipation of this shift in policy, and also given the steep yield curve which had underperformed other emerging markets. Against this position we remained underweight the rand and South African sovereign credit.
Ukrainian sovereign debt performed well over the month, buoyed by the comprehensive election win by President Zelensky’s “Servant of the People” party. Zelensky achieved a majority, which is a first in Ukraine’s modern history. We initiated a position in Ukraine local bonds over the month which we expect to benefit from falling inflation and very high real rates.
Geopolitical tensions remained high in the Middle East with the shooting down of an Iranian drone and the seizure of a British tanker. We expect tensions in the Gulf to remain for some time yet with the US keeping up their “maximum pressure” strategy and the Iranians in turn gaining leverage for negotiations by unwinding elements of the Joint Comprehensive Plan of Action (JCPOA/ Iran nuclear agreement). However, with risks of an all-out conflict still relatively small, oil prices continued to weaken with the market focusing more on global growth concerns.
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. We also retained our exposure in the long-end of the Saudi Arabian yield curve, which still looks steep to peers and history.
In the high yield space, we took advantage of new issuance to add a position in Oman. While spreads have tightened since June, we believe they still offer value 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 where the country remains committed to an extended IMF programme and the country’s external indicators are continuing to improve.