Doubts creep in over emerging market outlook

Flows into emerging market (EM) debt have accelerated over the last three years and already exceed $19bn (E14.7bn) year to date compared with $10bn for the whole of 2011, according to JP Morgan data. Investors have been attracted by the significant yield pick up in emerging markets, compared with the scarcity of yield on the highest rated government bonds, coupled with growth prospects in emerging countries, and low debt levels which many believe have permanently improved.

This boundless enthusiasm for the asset class is now looking over-optimistic. Yields are at record lows and spreads over developed market bonds are at tight levels. According to the JPM EMBI+ index of external debt bonds, spreads over US Treasuries are now 3 per cent, compared with almost 9 per cent in 2008. Even when prices fell last September, investors kept buying, despite signals that growth was slowing in China.

However, as long as conditions remain in place for a repressive monetary environment, and at least five central banks are still cutting rates, the current situation could yet become overblown. In fact, Julian Adams, chief investment officer at Adelante Asset Management, compares emerging market bonds with technology stocks in July 1999. He believes conditions could go to an extreme overblown level, unless there is a surprising uptick in global growth, but that looks unlikely as Europe is still in recession and Obama has a massive battle ahead with Congress.

Certainly, the resilience of these markets this year has been surprising. At Pioneer Yerlan Syzdykov, senior portfolio manager, emerging markets and high yield, says he was caught out by the resilient of demand in this risk-on/risk-off environment. EM bonds have returned a stellar 13 per cent year to date, rather more than the 7-8 per cent he anticipated for the whole year.

“Both pessimists and optimists see it as a safe haven which puts emerging markets in a sweet spot,” says Mr Syzdykov. Whatever the newsflow, ECB and Fed action have a positive impact on emerging markets which have been seen as a good investment destination both as a stable and safe market and as a growth one.

“This is a paradigm shift,” he says. “Traditionally, wherever there is a sell off in developed markets, there has been a run on emerging markets, but now the crisis in the developed world is actually pushing investors into emerging markets. The only time we saw a negative pressure was the sell-off in Treasuries which typically happens when economic newsflow in EM is negative,” explains Mr Syzdykov.

“We still believe that the global negative economic picture and EM economic performance do not warrant current valuations so we continue to be bearish – but we have reduced our negative bias 30 per cent, as a third of the cash we held in the first quarter is now invested,” he says.

WORRIES OVER CHINA

Critically, the view of China as Santa Claus, always providing growth for the world at double digit rates, is beginning to crumble. “The decoupling effect is not going to hold true,” argues Mr Syzdykov. “China is already

slowing down and its growth in industrial production is coming to a halt and the perception that EM will always grow faster will be challenged. The near term shocks could be swift.”

‘Investment tourism’ is a persistent problem in these markets as many investors do not really need to be there, such as hedge funds and even pension funds, so flows could leave quickly.

“The question is, is it different this time or is it long term money,” says Christopher Wykes, product manager, emerging market debt, at Schroders. “As the bulk of investors in this market are not permanent, the risk is that a fall in EM debt markets could well prompt a flood of foreign selling as has happened repeatedly in the past, such as in 1998, 2001 and of course 2008. A trigger for such a sell-off could well come from the realisation that the growth prospects in some leading emerging countries are not as rosy as many western investors currently believe.”

HIGHER YIELDS

Most managers believe that yields in EM debt will go significantly higher in the next 18 months, and that investors should be cautious about buying a beta exposure after such a long extended rally, especially when growth is being questioned and inflation is picking up.

Year to date, external debt has returned north of 12 per cent, while local debt has lagged with 9.7 per cent, and the consensus is external debt in strong economies such as Russia, Brazil & Mexico has limited room for further tightening. Most managers are therefore switching away from dollar-denominated debt and are sampling where there could still be considerable yield compression. For example, Russian 2018 USD Bonds yield 2.5 per cent while local bonds of the same maturity are paying 7.6 per cent. Currency markets experienced a huge sell-off in the second half of last year which has not been recouped, and the third round of quantitative easing from the Fed will help local currencies by damaging the dollar.

Mr Adams likes the Mexican peso which is linked to US growth and has the potential to recover, and the Brazilian real as the central bank intervened to devalue it by 15 per cent and, with a less aggressive stance, the currency could recover.

As they are benchmarked against an index that is triple BBB rated, fund managers tend to study credit ratings closely, and are also adding to their lower-rated high yield positions. There has been little spread compression in Argentina and Venezuela, for example, where bonds are yielding 12 per cent, in comparison with, say, 2.5 per cent for 10 year Mexican bonds.

Pioneer’s Mr Syzdykov suggests it could be time to change attitudes to Ukraine, which is trading at 800 bspts so reflecting its higher risk, but he believes it could easily trade at 900-950 bspts as it faces a refinancing dilemma and election and will have to renegotiate expertly with the IMF to avoid a default or restructuring.

While Venezuela and Argentina are popular overweights, Lebanon, which now constitutes 3.5 per cent of the index, is a common underweight because it has become highly rated but its fundamentals are poor and the bonds are typically owned by local banks which have incentives other than investors’ normal risk/return parameters.

The corporate market is of very high quality and booming on the back of macro economic stability. “Issuance is strong and there are relatively few dedicated EM corporate bond investors so the market is inefficient and a good hunting ground for those who can analyse this market,” says Bart van der Made, lead investment manager, emerging markets debt at ING.

“However, it is not as liquid as sovereign markets so I typically look for larger corporations in larger countries, such as Brazil and Russia.”

Nathan Chaudoin, emerging market debt investment director at HSBC Global Asset Management, says he has also switched his focus to corporate issuers with strong balance sheets in high quality countries such as Russia, Brazil and Mexico as well as sovereign bonds in high beta nations with attractive spreads and improving fiscal dynamics, as these countries will benefit from a stabilisation in eurozone growth following the ECB’s much-anticipated Outright Monetary Transactions scheme.

Many managers, such as Michael Gomez, co-head of emerging markets at Pimco, continue to like quasi sovereign debt, such as Gazprom in Russia, which fall somewhere between corporate and enjoy an implicit claim on the sovereign to pay the debt in the event of default.

Mr Gomez and others argue that the market will continue to see “a continuation of a long-term trend of more and more investors looking at emerging markets to play a role in portfolio solutions because of their high growth rates, clean payment profiles and high and stable levels of yield and carry”. The contrary and more holistic view is that we are at the end of a 31 year bull market in bonds.

“When 10 year US Treasury bonds are at 1.5 per cent, then it seems certain that the next significant move is up,” says Mr Wykes at Schroders. “In 10 years’ time, most investors will have less of their wealth in bonds than they do today. The rally in Treasuries in the last few years is unrepeatable. Thus investors are likely to have a lower proportion of their portfolios in bonds but a core part of that lower exposure should be in EM debt – to enhance returns and to reduce risk, not just to enhance yields.”

Corporates remain attractive

Most wealth managers concur that over the medium to long-term emerging market bonds should continue to benefit from better fundamentals than those of developed markets, but they warn against piling in too heavily now after a strong bullish phase for the sector.

“We recommend building up exposure in a well-diversified way and would fund this using cash positions and by reducing exposure to developed market government bonds,” says Gareth Thomas, portfolio manager at UBS Wealth Management UK.

“In the current environment we prefer increasing exposure to EM corporate bonds, which are particularly attractive due to their favourable valuations, solid fundamentals and relatively short duration. Good economic growth and low interest rates have helped EM corporates grow their profits while keeping their balance sheets intact.”

Since 2003 corporates have overtaken sovereigns as the main issuers of new USD-denominated EM debt, explains Mr Thomas. “While EM corporates issuing too much debt can at some point become a risk rather than an opportunity, we believe the asset class is still in a healthy growth mode,” he says.

“As EM corporates have markedly improved their balance sheets in recent years, they have gained better access to capital markets; we expect this trend to continue over the coming years, thus developing the asset class and improving its liquidity profile.”

Investors should be aware that after strong performance year-to-date the room for spreads to narrow further from current levels is more limited and lower returns should be expected over the rest of the year, warns Mr Thomas.

“The risks of the market should not be underestimated,” warns Georgios Tsapouris, investment strategist at Coutts. “In the past there has been a strong performance so people became lax and thought it would produce good returns every year. But a market correction of 15 per cent in just a few weeks last summer has reminded investors that it is a high beta trade.”

“The JPM Global Diversifier index is up 11 per cent year to date, and the largest component of that is spread contraction, but with international rates close to zero, the big component of future returns will be currency,” adds Mr Tsapouris.

“Currency gains have historically been the biggest component of EM local debt performance and EM currencies are likely to benefit as central banks in developed markets start a new round of monetary easing.” He generally like active funds for this space as the dynamics of EM countries vary significantly. An active manager might want to avoid India, he suggests, where the high deficit, inflation and low growth have created a dead end situation and growth is low.

Coutts has holdings in BlueBay, Pictet and Investec.

VIEW FROM MORNINGSTAR

Gaining momentum

As investors flocked to the perceived safety of US Treasuries and hard currencies during the second half of 2011, concerns over the global slowdown led them to shun emerging market bond funds. This trend reversed during the first half of 2012, with such funds gaining momentum as investors’ risk aversion partially subsided. The JPM EMGBI EUR Hdg index returned 11.7 per cent over the past 12 months, boosted by positive returns from lower-risk countries such as Poland and Mexico.

Funds in the Morningstar Global Emerging Market Bond – EUR biased category returned an average of 9 per cent, with a large dispersion between the best and worst performers (16.4 per cent and -6.15 per cent respectively). The number of funds in this category has increased in recent years, yet investment strategies can be different, especially in terms of currency exposure.

Schroder ISF Emerging Markets Debt Absolute Return A1 € Hedged invests primarily in sovereign and corporate bonds issued in emerging markets, but its currency exposure is fully hedged back to the euro. The manager, Geoff Blanning, pays little heed to the benchmark, in keeping with the fund’s “absolute return” goal. When opportunities on local emerging market bonds are scarce, Mr Blanning will not hesitate to hold cash and defensive investments, such as US Treasuries. This has at times detracted from performance, as was the case over the first half of 2012, when the fund was unable to capture most of the rally in emerging-market bonds.

In contrast, Pictet-Global Emerging Debt delivered 13.1 per cent over the period. The fund emphasises emerging market bonds that are denominated in US dollars, and this positioning contributed positively to its performance.

Mara Dobrescu, fund analyst at Morningstar’s Paris office