A silver lining of the Trump administration’s protectionist agenda has been that emerging market (EM) governments have, on the whole, reaffirmed their commitment to freer trade. Reassuringly, they recognise the positive influence of open markets in driving EM economic growth over the last three decades.
While Trump stole much of the headlines from the APEC meeting over the weekend, 11 countries (including Malaysia, Chile and Peru) finally agreed to push ahead with a revised version of the Trans Pacific Partnership (TPP)*. This strongly signalled remaining participants’ commitment to trade liberalisation, despite Trump withdrawing from the agreement during his first day in office. Even without US involvement, the scale of the prospective agreement is significant – 500 million people and over US$10 trillion in aggregate GDP. That said, without US involvement, the economic gains are more modest. A recent paper from the Peterson Institute for International Economics (PIIE) highlighted the economic benefits of TPP (ex-US) would be limited to approximately US$150 billion, or less than half the benefits of the agreement with US participation. However, if the five other Asian countries that have shown an interest in the agreement were to join then the economic benefits would approach those of the original TPP according to the PIEE analysis.
Also at the weekend was a modestly disappointing delay to the other large putative Asia-centric trade agreement, the Regional Comprehensive Economic Partnership (RCEP)**. A ministerial meeting at the side-lines of the Asean summit in Manilla decided to push back the timeline till 2018 (there had been hopes it could be signed this year).
A trade deal does, however, still seem very likely. RCEP is regarded as a lower quality trade agreement than TPP (limited coverage of services & investment, and weaker labour and environmental provisions), however it covers a much larger GDP base (4 of 10 largest global economies are in RCEP). PIIE estimate global income gains of around US$300 billion and the economic benefits could be significantly higher if countries like Japan and Australia manage to succeed in getting some services provisions into the agreement. Moreover, both agreements can facilitate a framework for further rounds of gradual trade liberalisation (possibly with US involvement under a more receptive administration).
Admittedly both trade agreements have a long way to go, although the progress to date shows that the world is moving ahead with trade liberalisation despite the US flirting with protectionism. This should help to underpin global trade growth over time. As Chart 1 shows, the rate of trade expansion has been lacklustre since the financial crisis – partly reflecting cyclical factors like the sluggish pace of global economic growth, but also structural factors such as the shortening of global supply chains (particularly in China).
The stalling of the Doha round of global trade negotiations and lack of progress on regional trade agreements has also likely played a significant role in the trade slowdown. Indeed, just a year ago, considerable gloom existed among trade economists. Now, fresh progress on trade agreements, driven in part by emerging markets, could help to underpin a longer-term re-acceleration in trade growth (which has already started to pick-up somewhat with the cyclical upswing in global economic activity). Thus, while there are significant concerns around the future of Nafta and Korea-US Free trade agreement, clearly the US administration is not going to be able to reverse the long-run trend towards greater trade liberalisation, and that EM governments recognise the importance of open trade for their economies.
Chart 1: Global trade volume growth (year-on-year %)
Source: Investec Asset Management, CPB Trade Monitor, November 2017
*TPP members: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam.
**RCEP members: 10 ASEAN countries + Australia, China, India, Japan, South Korea and New Zealand.
What we know:
Impact on bonds:
Our strategy from here:
The nineteenth National Congress of the Chinese Communist Party (the Party) was held from 18 - 24 October, followed by the First Plenary session today (25 October). As expected, President Xi cemented his status as the “Core Leader” of the Party; with “Xi Jinping Thought” having been enshrined into the Constitution. Furthermore, no obvious successor exists within the newly formed Politburo Standing Committee, increasing Xi’s chances of serving past his expected retirement in 2022. Consequently, the significance of other personnel changes was diluted, but from our perspective there will be little to distract President Xi from his policy agenda for the remainder of his term.
At the beginning of the National Congress, Xi’s Work Report laid out the broad plans for the next 30 years. Nevertheless, the market will focus most heavily on what to expect over the next 12 months. In terms of policy direction and momentum, we don’t expect much of a change over the short-to-medium term.
Firstly, Xi has long been considered the most powerful president for decades, so the last week has essentially rubber stamped a process which has been evolving over the last five years and was already well understood. Secondly, and somewhat related, we have seen an impressive shift in the gears of policy implementation over the last 18 months, with a clear focus on better supply side management. This contrasted with previous years where too much emphasis was placed on boosting demand through aggressive credit growth. As a result, the need for drastic policy change is limited at this stage. We therefore expect a continued focus on deleveraging, reducing excess capacity and pollution through SOE shutdowns and tightening controls on the property market to contain overheating risks.
From a portfolio perspective, we remain constructive on the Chinese renminbi. The balance of payments is in surplus as capital outflow pressures have eased significantly. Nevertheless, we still see some evidence of disguised capital outflows and hence do not expect any imminent capital account liberalisation. Trump’s visit to China next month comes as the trade balance between the two countries continues to widen, therefore ongoing currency stability or mild strength will be in China’s best interests.
It’s been a fantastic run for local currency emerging market debt (EMD) this year – up around 15% (in US dollars)1 and on track for its best return since 2009. Despite the strong rally, we believe that at a time of stretched valuations across other capital markets, local currency EMD is one of the few global asset classes offering genuine value. Both elements of local currency bond returns – yield and FX – appear to have room to appreciate further from current levels, particularly in high yielding markets.
If we turn to yields first, the GBI-EM weighted index yield is hovering around 6% at present. This remains relatively high compared to history, but on a real (inflation adjusted) basis valuations look even more attractive. The below table highlights the scale of disinflation across some of our key markets.
|Current consumer price index (CPI)2||10 year CPI average|
Source: Bloomberg, 30 September 2017
Pleasingly, monetary authorities have shown unprecedented discipline when reducing interest rates – a function of the increasing independence of EM central banks and their adoption of explicit inflation-targeting regimes (in countries as diverse as Argentina and Ukraine). While some central banks began easing monetary policy to support their economies – particularly in recession-hit countries like Russia and Brazil – they have done so in a largely credible fashion, ensuring inflation expectations remain anchored.
Consequently, interest rate reductions have generally been quite modest which has helped keep real interest rates and local bond yields high versus history. This relationship appears particularly noticeable when we compare the real yield between high and low yielding EM bond markets, as can be seen in Chart 1. In the high yield space, real yields remain close to their highs. With structurally lower inflation being sustained by credible central bank policy, nominal yields should continue falling outside of any external shock. By contrast, low yielding bond valuations look closer to fair value, although they don’t look exorbitantly expensive relative to history.
Chart 1: GBI-EM real bond yields across high and low yielding markets
Source: Haver, Bloomberg and IAM September 2017
Chart 2: EM real yield differential over developed markets remains elevated, and above its historic average
Source: Source: Haver, Bloomberg and IAM September 2017
This real yield buffer should continue to support foreign inflows, especially considering the attractiveness of EM currency valuations. On a nominal effective exchange rate basis 3, EMFX performance this year has been lacklustre given the strength of the euro. Similarly, using the real effective exchange rate (REER) method4, EMFX also looks inexpensive compared to history, particularly high yielding EMFX5. Even after accounting for the changed macro environment, we believe EM REERs for a number of high yield currencies remain 5-10% below fair value.
Chart 3: ELMI weighted REER high yield vs low yielding currencies
Source: Haver, Bloomberg, JPMorgan and IAM September 2017
The robust growth outlook across emerging markets should support further REER appreciation over the next few months, as we are still at a relatively early stage in this cyclical pick-up. As well as positive bond flows, equity flows should also be supportive given positioning remains light (indeed there has been net selling in recent months) and the fundamentals are improving, with net income margins rising, and as Chart 4 highlights, forward price-to-earnings (P/E) ratios6 still attractive relative to history and developed markets.
Chart 4: Developed vs emerging market equity valuations using P/E ratios
Source: Haver, Bloomberg and IAM September 2017
Thus we see fundamentals, valuations and positioning all still lining up positively to support local currency EMD over the medium term. With several emerging market economies also set to benefit from an increased stock of capital, technological progress and pro-market structural reforms this allocation argument is only strengthened.
1 As at 30 September 2017
2 Year-on-year change in the index
3 The weighted average rate at which one country’s currency exchanges for a basket of other currencies, not adjusted for inflation
4 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation
5 FX valuations need to be framed within the context of the end of the commodities super cycle, which drove the structural break in EM growth to a more sustainable, but lower rate, as well as driving the deterioration in in commodity terms of trade
6 The forward price-to-earnings ratio is a company’s current stock price divided by its estimated earnings per share
Falling oil prices, an import-dependent economy and multiple policy mistakes by authorities almost tipped Nigeria into depression. Over the last two years we have had little-to-no exposure to Nigeria on the back of our pessimistic view of Nigerian economic policymaking in an environment of lower oil prices. This strategy has not only saved our clients from significant losses, but also ensured that our EMD strategies faced no repatriation risks due to significant shortages of US dollars. However, in our view, an opportunity is beginning to open up and we are re-allocating to a country with improving economic fundamentals, more sensible economic policy settings and one which is priced attractively.
Accessing China’s interbank bond market is set to become significantly easier following the implementation of China Hong Kong Bond Connect (CHKBC) in July 2017. CHKBC forms a direct, efficient and transparent platform for offshore institutional investors to access the mainland’s debt market, and will almost certainly be the preferred bond market route for new investors. In our view, CHKBC will inevitably speed up the timing of China’s index inclusion and enable a constant flow of capital from international investors. The Chinese bond market remains a compelling investment opportunity given its yield and diversification benefits, and with operational barriers being broken down further this argument is only strengthened.
Our core EMD funds already have the flexibility to trade in China through either RQFII or CIBM direct. However, given the increased flexibility of CHKBC we can use this method for any future funds or segregated portfolios which have not yet had access to the Chinese bond market.
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.
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