Investors fear repeat of 2013 taper tantrum in emerging markets

Investors are agonising over a potential crisis in emerging markets, with the prospect of higher US interest rates looming in the autumn as ballooning debt issuance and reliance on non-domestic investors has left many emerging economies vulnerable. A rate rise by the Federal Reserve could stem capital flows to emerging markets by as much as 80 per cent, according to The World Bank.

However, many fund managers argue there are major differences between now and the ‘taper tantrum’ two years ago when developing country stocks plummeted after the Fed said it would wind down its bond-buying programme. This time, the potential for a rate increase has been well signalled, external debt is lower and emerging market assets are priced more reasonably. Many countries such as India and Mexico have made progress in economic and structural reform, while the travails in Brazil and Russia have scarcely moved their respective currencies.

 “It’s been two years since big taper sell-off,” says Jim Craige, portfolio manager at Stone Harbor Investment Partners. “Fast forward two years and we are in a period of uncertainty regarding global growth but the real fear is that when the Fed begins to hike rates it will hit emerging markets again. We don’t think that is likely. The asset class is not a hedging vehicle as it was in 2013, and is instead in more stable hands.”

The difference between now and 2013 is that there are better growth prospects in emerging markets today and better potential currency appreciation, he adds. Another key difference is that the Fed has prepared markets for a lift off in rates but it will be a very “kid gloves” affair with guidance to comfort the market and at the same time on the emerging markets side, valuations are very different, explains Mr Craige. Real exchange rates have depreciated in the last three years, making markets cheaper now.

Policy initiatives, particularly in the more fragile countries, for example Brazil, where interest rates have been hiked to nearly 14 per cent to gain credibility, as well as implementing reforms and tackling fiscal credit – and in Turkey where interest rates have been set at 10.75 per cent, should provide some comfort, he believes.

However, economic data from some emerging nations has been worsening over the summer, notably in Brazil where the central bank recently raised its inflation forecast to 9 per cent, from 7.9 per cent three months ago, and now says gross domestic product will contract by 1.1 per cent this year, compared with its earlier forecast of a 0.5 per cent decline.

Rising prices, sluggish growth and high interest rates are hindering President Dilma Rousseff’s efforts to stoke the economy, such as extending consumer credit from state-controlled banks, cutting taxes, and raising public spending and energy subsidies. Moody’s now rates Brazil’s debt at just two notches above junk, with a negative outlook, and a downgrade may prove unavoidable.

As the dollar continues to strengthen, there are also concerns about the ability of governments to service debt issued in the US currency, which will increase the debt burden, particularly those countries with large current account deficits and high inflation, such as South Africa, Turkey and Brazil. The International Monetary Fund has asked the Fed to be conscious of the impact an interest rate rise would have on the rest of the world.

Political volatility is also rising in pockets. “We are quite defensive,” says Yerlan Syzdykov, head of emerging markets debt at Pioneer Investments.  He is preparing for some volatility, not so much concerning Greece, where he believes the situation will be resolved without contagion to the wider market and to emerging markets in particular. Rather Mr Syzdykov is more concerned that traditionally more stable countries such as Turkey are becoming politically volatile, which now has a multi-party configuration, which is discomforting. Other more benign countries where volatility has increased are Poland and Romania, where significant challenges are coming from the political side. There are also negative pressures in the Balkans (Croatia and Serbia in particular), where debt is moving to dangerous levels and the EU will be paying a lot more attention to leverage in the economy post-Greece debacle, he explains.

 “So the Emea is collecting pressure points, with pain in Romania, Croatia and Serbia, and it all adds up,” warns Mr Syzdykov. “Even in relatively politically stable countries such as Hungary, the situation will probably start to reverse.”

The consensus is that the Fed’s increase in interest rates will be slow and gradual but it may not be as slow and gradual as expected.

“One worrying aspect is that prior to the Fed taper in 2013, although everyone knew the taper was going to happen, they did not know when it was going to occur and by how much, and the market then had a shock,” explains Simon Lue-Fong, head of emerging debt at Pictet Asset Management. 

“The Fed rate hike could be similar. We don’t know when and by how much and maybe it is not fully priced in. We need to get through that. Personally I don’t expect strong returns from here to the year end because of the Fed hikes and sub-par growth.”

The balance sheets of emerging markets are still in pretty decent shape, he adds. Apart from Ukraine and Venezuela, there are not too many worries about countries’ ability to pay back debt. But investors should be cautious as if the Fed hikes rates and yields move higher, then this (dollar-denominated) asset class will be under pressure as the safer asset class will attract flows, says Mr Lue-Fong.

 “Of currencies, local debt and dollar debt, it is currencies that are the most challenged,” he explains. “Weakness in commodity prices have impacted export markets, and we expect to continue to see that trend for currencies to be under pressure. At the end of the year there may be some opportunities but not now.”

 Certain emerging market central banks have been trying to cut rates this year such as China, Korea and Indonesia, keen to help their economies, pre-empting the Fed rate hikes, but the nearer we get to that day, the harder this is to pull off, adds Mr Lue-Fong. On the fiscal front, many emerging countries do not want to expand. Therefore, as they are constrained on both the monetary and fiscal fronts, currencies are the remaining rebalancing tool and are expected to go lower.

 “Emerging market local bond returns will therefore remain under pressure but at the moment that would be offset by a decent carry of 6-6.25 per cent, but the asset class will not offer high returns,” he predicts. 

Since the taper in May 2013, wholesale and retail investors exited these markets quickly but institutions for the most part stayed invested. Most of the outflows were on the local currency side but the dollar-denominated debt story continued to have appeal. The local market index (GBI-EM) has lost 5 per cent year-to-date and has been negative for four to five years. In contrast, dollar-denominated debt is up 2 per cent in the year to 1 July. 

Most asset managers prefer dollar-denominated bonds over local currency securities as they expect emerging market currencies to weaken and dollar denominated bonds to deliver a positive return compared with a decline in local currency debt.

The sector most at risk is corporate debt as the market has been flooded with new issuance as bank lending dried up. The corporate sector has more than doubled since 2010, and default rates could increase as the dollar strengthens.

“There is a feeling that the asset class is facing a lot of headwinds and is a difficult place in which to invest but the story is more nuanced than that,” says Matt Ryan, emerging markets fixed income portfolio manager at MFS IM. “It is an asset class with plenty of opportunities, but where investors really need to be selective, both by country and credit selection. Over the next two years it will be more of an alpha than a beta story, more bottom-up country, currency and rate decisions and less thematically-driven investments.”

Volatility creates opportunities as good credits and currencies get driven down with the bad, adds Mr Ryan, but the headwinds are largely cyclical and a number of structural measures implemented over the years have made it more resilient. “For example, 10-15 years ago a number of countries had fixed exchange rates, whereas today most are flexible and that takes a lot of pressure off countries’ external accounts.”

Differentiation among countries is expected to escalate, as some have healthy current account and fiscal balances with strong export-driven economies, while others struggle with deficits and economic imbalances, a trend that has helped spawn tactically managed blended funds, which are 50 per cent local and 50 per cent dollar-denominated. 

The lower oil price is also amplifying the differentiation across these markets. Some oil-exporting emerging-market economies have been pressured by both the collapse of oil prices and periods of depreciation of their currencies against the US dollar, says Michael Hasenstab, portfolio manager of the Templeton Emerging Markets Bond fund.  However, emerging market economies that net import oil have generally benefited from declining prices. 

“In our view, this variegated environment should provide attractive opportunities for a fundamentals-driven investment strategy,” he predicts. “Although there was a high correlation of risk aversion across emerging markets over the months when oil prices declined and global growth forecasts were revised downward, we believe individual country fundamentals are likely to re-emerge over the medium-to-long term.”   

Proceed with caution

While asset managers have been beefing up their emerging market debt teams as an area of growth opportunity for their businesses, wealth managers are typically cautious on the sector.  

“The current fundamental backdrop in emerging markets is weaker than it was during previous periods of US monetary policy tightening,” says Timothy Tay head of Asia credit research at UBS Wealth Management. 

Growth prospects in emerging markets remain subdued and credit fundamentals have not improved, he warns, and while recent PMI numbers suggest EM economies are gradually getting better, the extent is likely to be moderate. China’s ongoing policy measures should prevent a pronounced slowdown there, but growth dynamics are muted. 

“This increases uncertainties for the broader EM region and limits the upside for commodity prices,” says Mr Tay. Elsewhere, Brazil and Russia are currently in recession. Regionally, credit ratings in Russia and Brazil remain under the most pressure, while Chinese issuers in the non-cyclical sectors remain stable, bolstered by policy easing, he says.

 “Despite the significant corrections in several markets since May 2013, many emerging market exchange rates have not yet reached levels we would consider attractive,” adds Michael Bolliger, UBS Wealth Management’s head of emerging market asset allocation. “If emerging market policymakers want to succeed in fostering growth, further FX weakness is one of the very few policy tools left in their arsenal. We would recommend investors buy EM corporate bonds in dollars rather than local currency bonds.”

View from Morningstar: China and central banks the hot topics

While the Greek sovereign crisis has been one of the biggest concerns for global fixed income markets since the beginning of the year, the news coming out of several emerging markets also provided ample fodder for speculation. 

Primary among them was China, where economic data points to slowing growth, with official statistics revealing a drop in property prices. The question in the forefront of many investors’ minds is whether the adjustment will occur gently or take the form of a ‘hard landing’ with dramatically shrinking growth creating a trade shock for China’s major trading partners such as the US and many Asian countries. 

In other areas of the market, Venezuela and Russia, two countries which saw their debt sell off dramatically in 2014, posted significant gains in the first half of 2015 as government measures to curb inflation seemed to meet with some success. Meanwhile, the price of debt issued by Ukraine has continued to slide as the country attempts to renegotiate its outstanding obligations. 

More generally, fixed income investors in both developed and emerging markets have continued to keep a close eye on central bank involvement in debt markets worldwide. Market participants continued to brace for an eventual hike in US interest rates later this year, which would be the first in almost a decade and could curb the flow of liquidity that has been pouring into emerging markets in the past few years. 

Within Morningstar’s Emerging Markets Bond categories, the Silver-rated Templeton Global Bond continued to suffer from its exposure to Ukraine (7.9 per cent of its assets in May 2015) and ranked in its peer group’s bottom quartile year-to-date. Manager Michael Hasenstab and his team started building that stake in 2010, encouraged by the country’s young and educated population and strategic importance to Europe. Franklin Templeton is currently participating in discussions with Ukraine’s government and the IMF to renegotiate its debt, but the outcome remains uncertain and the fund has felt the full impact of this volatility. 

Bronze-rated MFS Meridian Emerging Markets Debt fund has fared much better, beating 78 per cent of its peers over the first half of 2015. Managers Matthew Ryan (whose involvement in the fund dates back to 1998) and Ward Brown are former IMF economists and are supported by a well-resourced analyst team. 

As of June 2015, the fund’s main distinctive characteristic was its overweight position on Mexico (14.4 per cent of assets compared to 6.7 per cent for the category norm). Security selection in the country (particularly in quasi-sovereign and corporate bonds) contributed positively to recent performance, particularly in the second quarter of 2015, as did the underweight on duration during a period of rise in US Treasury yields. 

Neutral-rated NN Emerging Markets Debt has also outpaced the majority of its competitors year-to-date, benefitting in part from its larger exposure to Venezuela. Nonetheless, Morningstar manager research analysts have no strong conviction in the long-term fundamentals of this offering. 

At the beginning of 2013, the emerging markets team at NN was entirely revamped, with 18 of its 27 members moving to a competitor firm. ING IM had the hard task of almost entirely rebuilding the team, which they managed to do within one year. The new team, headed by Jeremy Brewin, is sufficiently well staffed, however it has no substantial public track record and its tenure at the helm of this strategy is still too short to draw any meaningful conclusions.

Mara Dobrescu, Manager Research Analyst, Morningstar