1. Art and Diseño

Indicator
Emerging Market Fixed Income
Emerging Markets Debt
October 2014
Views expressed as at 10 October 2014. All returns below in US dollars unless otherwise stated.
At a glance
• The JP Morgan GBI-EM Global Diversified Index fell 5.11%. Bonds were down 1.02%, while currencies fell by 4.09%.
• US economic data remained relatively strong, prompting a more hawkish statement from the Federal Reserve which
supported a strong dollar and led to higher US Treasury yields, with a knock-on impact for emerging market debt.
• Topic of the Month: What does US Dollar strength mean for emerging markets?
Recent developments
It proved a challenging month for emerging market debt, especially when measured against the US dollar. With US
economic data remaining relatively strong, the Federal Reserve (Fed) tweaked its forward guidance. While maintaining
that near-zero interest rates will remain in place for some time yet, they have indicated that when rates do start rising,
they will do so at a quicker pace than previously communicated. As a result US Treasury yields have trended higher
with some knock-on impact for emerging markets.
Chinese data deteriorated somewhat with industrial production growth hitting a six-year low, while demand for loans
moderated significantly in the third quarter. There was also a sharp rise in non-performing loans during the first half
of the year. This prompted the Chinese authorities to inject US$81 billion into the country’s banking system, although
it was noteworthy that policymakers appear to have become more accepting of the country failing to meet its 7.5%
growth target. Protests in Hong Kong took centre stage towards the end of the month, something which will be closely
monitored as developments unfold.
Elsewhere in Asia, dataflow was mixed, with purchasing managers' indices (PMIs) generally moderating over
the month, although as a region, Asia still looks in decent shape compared to other regions. Latin American
macroeconomic data showed some modest signs of improvement with industrial production modestly exceeding
expectations in Mexico and Brazil. The effects of the sanctions against Russia have been felt in eastern and central
Europe, most notably in Poland with PMI and industrial production turning significantly weaker.
Local currency bonds, as measured by the JP Morgan GBI-EM Global Diversified Index fell 5.11% over September.
Bonds were down 1.02%, while currencies fell 4.09%. The Brazilian real was the worst performing currency as
sentiment weakened given the uncertainty surrounding the presidential election and the S&P’s outlook downgrade. The
Russian ruble fell to new lows versus the US dollar as further sanctions loom on the horizon and oil prices sliding well
below $100 a barrel. By contrast, the Nigerian naira was the best performer following intervention by the central bank
to prop up the local currency. The Chilean peso and Peruvian new sol also performed relatively well.
Hard currency bonds, as measured by the JP Morgan EMBI Global Diversified Index, fell by 1.81%. The index yield
ended somewhat higher at 5.40% while spreads over US Treasuries rose to 299 basis points. The best performing
hard currency bond market was Argentina, followed by Ghana and Honduras. By contrast, the worst performers were
Venezuela, Uruguay and Ecuador.
Corporate bonds, as measured by the JP Morgan CEMBI Broad Diversified Index, fell 0.86% with spreads rising
slightly to 298 basis points. Investment grade bonds (-0.78%) outperformed high yield bonds (-1.02%). The top
performing sector was financials, with real estate and transport also holding up relatively well. Metals & mining was the
weakest sector, while TMT and oil & gas were also particularly weak. Regionally, central and eastern Europe held up
reasonably well, while Latin America was the weakest by some margin.
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Outlook and strategy
The global growth outlook remains mixed. In developed markets, we continue to witness divergent fortunes; while the
US continues with its impressive recovery, Europe and Japan look decidedly shaky. We expect this theme to broadly
continue over the coming months, and consequently the impact on individual emerging markets will be varied. Chinese
data flow has turned weaker again, focused mainly in the manufacturing and property sectors, but the services sector
should help to offset some of this weakness, meaning growth should stay between 7 and 7.5% this year. Markets
have become more concerned about the pace of Fed tightening, with forward guidance now indicating interest
rates are set to rise at a faster pace than previously communicated, helping to explain the accelerated pace of US
dollar appreciation. While we expect Treasury yields to rise, we expect this process to be gradual, rather than for a
sharp correction. The negative impact of Fed tightening on global liquidity conditions should be partially offset by the
European Central Bank’s easing cycle and there is also an increasing possibility of the Bank of Japan undertaking fresh
monetary stimulus.
Portfolio flows into emerging market debt were modestly stronger in September. We still feel positioning is relatively
light and with comparatively attractive yields on offer we expect flows to remain generally supportive. On a more
structural view, we believe global investors, particularly US institutional investors, remain structurally under-allocated
to emerging markets which will provide a tailwind for flows over the medium term. Emerging market inflation has fallen
from its June peak and the outlook remains relatively benign as food and oil prices continue to moderate. This should
help to mitigate the impact of pass-through from the stronger US dollar.
Overall, we believe global growth patterns, positioning within the economic cycle and the external financing
requirements of individual emerging market economies will remain significant determinants of individual market
performance. Political developments will also be important to watch. In particular, the second round of the Brazilian
presidential election will be on our radar, following the surprisingly strong performance of opposition candidate Aécio
Neves in the first round.
Topic of the month: What does US Dollar strength mean for emerging markets?
Introduction
After a summer of trendless markets and exceptionally low volatility, the autumn has started with one very clear and
strong theme: a stronger US dollar (USD). Historically, such trends in the US dollar have tended to create significant
headwinds across emerging market economies and assets.
However, in this post global financial crisis world, we believe that care must be taken in drawing lessons from
historical periods of US dollar strength. The rate hiking cycle in the US may look quite different this time from
previous episodes. Other large developed economies such as Europe and Japan may be easing as the US tightens,
providing some offsetting effects. And most importantly, many emerging markets have transformed themselves in a
number of important ways over the last 15 years since the US dollar last rallied, making themselves significantly less
vulnerable this time around.
Why is the USD strong again?
Market expectations at the start of the year were for a further rise in the long end of the US yield curve, with the 10year yield expected to push well above 3%. Instead, a pothole in US GDP growth in the first quarter, combined with
strong technical demand and risk aversion to the Russia-Ukraine crisis, pushed the US yield curve lower. The US dollar
was quite weak, in particular versus emerging market currencies, and trading volumes across many assets fell as
volatility diminished. The markets became complacent.
A strong rebound in growth in the second quarter and continued improvements in the labour market meant that by
late August, focus turned to the fact that market expectations of US interest rates were anticipating slower hikes
than the Federal Reserve’s (Fed’s) own projections. As a result, short-term US interest rates started to move up, and
this trend accelerated when the Fed revised its own estimates up quite sharply at their mid-September meeting, as
shown in Chart 1. The changing differential between short-term US interest rates and those elsewhere is a key driver of
developed and emerging market currency movements, as well as US dollar denominated commodities.
2
Chart 1: Market pricing vs Fed expected pace of rate hikes on day of September 2014 FOMC
5
4
3
2
1
0
2014
2015
2016
2017
Longer Term
Sep 2014 Median
0.125
1.375
2.875
3.75
3.75
Jun 2014 Median
0.25
1.125
2.5
Fed Funds Futures
0.099
0.819
1.854
Minutes Sep 2014
Sep 2014 Median
Jun 2014 Median
3.75
2.527
Fed Funds Futures
Source: Investec Asset Management; FRB; Bloomberg
We believe it is important to differentiate between this current period of US dollar strength and the events of mid-2013.
At that time, longer-term US interest rates had moved to very low levels, such that the ‘term premium’ (the excess
yield on long-term vs short-term bonds) investors usually demand for the risk of holding longer-term bonds had turned
negative; see Chart 2. The subsequent rebound in the ‘term premium’ caused the so-called ‘taper tantrum’ which
hurt emerging markets which are more sensitive to longer term US interest rates. Today the ‘term premium’ is at more
reasonable levels, suggesting less risk for emerging markets.
Chart 2: US term premium (%) – measure of long-term interest rate uncertainty
2.5
5yr estimated term premium
2
1.5
TAPER
1
0.5
0
QE
-0.5
-1
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: Investec Asset Management; FRBNY
3
This is broad USD strength, not just against EM Currencies
In fact, developed market currencies and commodities tend to be more sensitive to short-term US interest rate moves.
The dollar index against G10 currencies (DXY) rose 8.6% in the third quarter, whilst Brent crude has fallen 22% in USD
terms over the same period. Chart 3 shows the performance of the JP Morgan emerging market currencies index
(EMFX) in Euro and Yen terms, where emerging markets have posted gains over the last few months. Consequently,
the risk of material outflows appears lower as many investors have not suffered losses. Further aggressive monetary
policy easing from both the European Central Bank and the Bank of Japan appear quite possible in the first half of
2015. This will not only ensure that outflow pressures remain limited from investors based in these currencies, but more
fundamentally means that liquidity from these central banks may partially replace the gradual withdrawal of US dollar
funding which has been ample for emerging markets over the last decade.
Chart 3: JP Morgan EMFX index vs major developed market FX
110
in USD
in EUR
in JPY
105
100
95
90
85
80
Jan 2013
Mar 2013
May 2013
Jul 2013
Sep 2013
Nov 2013
Jan 2014
Mar 2014
May 2014
Jul 2014
Sep 2014
Source: Investec Asset Management; Bloomberg
Importantly, the decline in many commodity prices has outstripped the fall in EMFX. Chart 4 shows Brent crude oil
priced in selected emerging market currencies – the prices faced by domestic consumers. Unlike in 2013, the price
is falling across all emerging markets, helping to lower inflation and deliver relative stability in local currency bonds. In
countries such as Turkey where further currency depreciation is needed to adjust still-large current account deficits, the
central bank can allow this without risking spiralling domestic prices. Of course, declining commodity prices are not
good news for all emerging markets, and may weigh on some markets such as Nigeria and Chile.
Chart 4: Brent crude denominated in selected emerging market currencies
130
in KRW
in TRY
in INR
Jul 2014
Sep 2014
120
110
100
90
80
70
Jan 2013
Mar 2013
May 2013
Jul 2013
Source: Investec Asset Management; Bloomberg
4
Sep 2013
Nov 2013
Jan 2014
Mar 2014
May 2014
Big picture: this is different from the USD cycles in the 1980s and 1990s
Some commentators have drawn parallels between the events of recent weeks and the start of the multi-year USD bull
markets of the early 1980s and late 1990s, when the US again was largely the world’s only growth engine. There are
reasons to believe that coming quarters may not see such a strong US dollar cycle, and certainly not with the same
broad negative implications for emerging markets:
1. Many economists now estimate long-term potential US GDP growth rates at less than 2%, an assessment we
would certainly share. In the early 1980s and late 1990s structural reforms and the technology revolution pushed
potential US GDP growth above 3%. This meant the Fed had to raise policy rates much higher than it will do this
time around.
2. The US basic balance of payments (current account plus long-term FDI) was in a small surplus at the start of
the historic USD rallies. Whilst it has improved in recent years thanks to domestic energy production in the US, it
remains in a modest deficit, creating some further headwinds.
3. Since the 1997 Asian financial crisis, most emerging markets have decreased the proportion of debt issuance
denominated in US dollars and so there has been a drastic improvement in the net USD debt position of all
but a few countries. The exposures to a stronger USD which triggered the string of EM crises in the 1980s and
1990s have been reduced to levels where they are well covered by foreign currency reserves in all but a handful
of emerging markets. While sovereign debt is covered by such reserves, we acknowledge that there has been a
significant increase in corporate USD debt exposure in the last three years.
4. Many emerging markets have made huge strides to reduce inflation to very manageable levels and create policy
anchors which anchor inflation expectations. This means currencies can move more freely to adjust to the domestic
economy without requiring drastic monetary policy interventions.
Conclusion: More differentiation within emerging markets from this USD rally
Instead, we feel that the current environment of modest USD strength, combined with sluggish Chinese growth and
resulting lower commodity prices, creates opportunities for investing in strong relative themes across emerging markets.
Terms of trade may continue to diverge, which will help drive currency movements. In particular, those emerging
markets geared towards exporting to the US will likely to see robust demand, while declining energy prices will prove a
positive trend for importers.
Whilst economies with greater external funding requirements should still feel depreciation pressures from further
adjustments in short-term US interest rates, we will also have to be alive to any increased probability of monetary
stimulus from Europe or Japan which could drive renewed performance in current account deficit countries.
Credible inflation anchors provide a further source of differentiation – many emerging markets have seen stable bond
markets and continued easing biases from central banks despite rising US interest rates. Those countries which more
credible inflation anchors can continue to deliver positive local bond returns in spite of the global environment.
Most significantly, an environment of modestly stronger USD places an additional premium on countries delivering
productivity growth and structural reforms. Countries which can deliver higher productivity will enhance their inflation
anchors through improved supply side dynamics, along with better fiscal fundamentals, further differentiating local
bond and credit returns. Their real effective exchange rates will also continue to appreciate on a long-term basis. Most
interestingly, several emerging markets including India, Vietnam and the Philippines are moving further in this direction.
The upcoming election results in Brazil may add another important name to the reform list.
5
Selected emerging markets at a glance
Central and eastern Europe
Czech Republic
Inflation ticked higher in September to 0.7% year-on-year but was lower than expected and slightly below the central
bank’s forecast. Activity data remains strong while higher consumer spending is being driven by the improving situation
in the labour market and a favourable fiscal policy. We remain underweight in koruna rates and neutral in foreign and
hard currency debt.
Poland
The central bank cut the reference rate by 50bps to 2%, in a more aggressive move than anticipated. In the press release,
the central bank emphasised a further deceleration in economic growth during the third quarter as well as continued
subdued inflation. We remain underweight in foreign currency, and market weight in local and hard currency bonds.
Romania
In line with our expectations the central bank cut its main policy rate by 25bps to 3%, and further reduced reserve
requirements on new leu-denominated liabilities. In its statement, the central bank emphasised lower-than-expected
inflation on the back of declining agricultural prices, subdued euro area inflation, a negative output gap and lower
inflation expectations. We remain overweight in local bonds and market weight in foreign and hard currency debt.
Hungary
Hungary’s economy is clearly picking up with growth expected to exceed 3% year-on-year in 2014. Public spending,
manufacturing and EU fund absorption are the main factors behind the sharp acceleration in investment. Despite the
strong momentum, it will be challenging for the Hungarian economy to maintain this rate of growth in 2015 amid a
slowdown of investment and headwinds for external demand. We are neutral in local and foreign currency debt, while
we moved to an overweight position in Hungarian hard currency debt.
Latin America
Brazil
Brazilian markets are very volatile and are primarily being driven by the unfolding political drama around the presidential
election. Dilma Rousseff won the first round, as predicted by the polls, but the sharp fall-off in support for Maria Silva
and Aecio Neves’ subsequent progression to the run off against Rousseff took the markets completely by surprise.
After a huge sell off in both the currency and the bond markets as Dilma’s poll ratings steadily improved, Neves’ strong
showing has swung the pendulum back towards a reasonable probability of a more market friendly administration and
pushed markets sharply higher. Against this backdrop, the challenges for the next president, whoever it is, are huge
and rising. The drought continues and inflation is creeping steadily higher again. Despite the challenges, we continue
to see value in the high local yields given the very poor growth outlook, and have used the recent sharp back up in
yields to increase our overweight. We maintain a small overweight in the hard currency bonds, generally preferring
other regional credits such as Peru. We also used the recent weakness in the Real to move back to marketweight, as
valuations moved more towards fair value.
Chile
Growth continues to be weak, although recent numbers have started to improve at the margin. Against this backdrop,
the central bank has remained dovish, cutting rates from 3.50% to 3.25% at its last meeting, with mixed indications
that there is a little more to come. We believe that with their still relatively upbeat growth forecasts for next year, which
are in line with our own, and still uncomfortably high inflation, the window to ease further has now almost closed. We
continue to hold our overweight peso position, as we believe it continues to present good value relative to copper and
that growth has bottomed. We also believe that the authorities are unlikely to have appetite for much more currency
weakness. Given this view and a somewhat more cautious view on inflation, we remain neutral local bonds, but stay
overweight in hard currency, which continues to look attractive relative to other regional investment grade credits.
6
Venezuela
We have continued to hold our overweight position in hard currency bonds relative to an Argentine underweight. The
performance of this credit has been a rollercoaster ride, despite the recent positive news that PDVSA will be able to
sell some USD at the weaker SICAD 1 and 2 rates, rather than at the official rate. We continue to expect to see these
modest responses from Nicolas Maduro’s government to the crisis. This, combined with our view that Venezuela
has the ability and the willingness to pay and service its debt over the medium term, keeps us constructive given the
extremely cheap valuations. We are, however, cogniscant that the debt and interest payments due in October are likely
to keep spreads under pressure until they are out of the way.
Argentina
Argentina continues to make unorthodox moves, tightening control where it can and putting the economy under
increasing pressure. Recent growth and inflation numbers have all printed better than expected, but once again we are
becoming increasingly sceptical of the reliability of this data. While Cristina Kirchner’s response to the U.S. Supreme
Court’s contempt of court ruling and a second coupon failing to reach restructured holders have done little to close
the growing rift between the government and the holdouts, it was the resignation of the central bank governor and his
replacement with a more pliable candidate that finally caused spreads to widen. We continue to believe that the market
is overpriced given the economic risks and the increasing probability that any resolution of the current default is likely to
extend into 2016 and a new administration. We therefore maintain our underweight position relative to Venezuela.
Colombia
Economic activity slowed at the margin but remains on track to be the regional outperformer this year, with
adjustments by market players concentrating more on the extent of the positive output gap than a marked
deceleration. However, the central bank left rates on hold and also halved dollar purchases to US$1bn, suggesting
comfort with current levels of the peso. We allowed dilution of our overweight in local bonds into the final instalment
of index rebalancing. We also took profits on our underweight position in the peso relative to the Mexican peso during
the recent bout of currency weakness. We remain comfortable with our overweight in hard currency on improving
underlying fundamentals.
Mexico
Forward looking indicators continued firming while continued rise in consumer confidence suggests prospects of the
recovery are already boding well for what has been anaemic domestic demand. Despite closing our long position in
the currency relative to the Colombia peso we remain constructive and expect it to be a long-term outperformer in the
region. Inflation is set to remain at the top of the band and combined with the impending normalisation of rates in the
US and deteriorating fiscal metrics, we continue to favour an underweight in local bonds. We hold our underweight in
hard currency as we see spreads largely pricing the strong fundamentals.
Panama
Reports of inflated government revenues and understated fiscal deficits for the first half of the year were confirmed
by the new administration as they sought to widen the ceiling of the fiscal rule. While the overiding expectation is
for President Varela to be more successful in reigning in spending than his predecessor, a still expansionary stance
targeting infrastructure and a less glossy starting point suggest that convergence is likely to be gradual. We remain
underweight dollar bonds.
Peru
Political noise has been on the rise in the lead up to gubernatorial elections, which comes after yet another cabinet
reshuffle that narrowly passed a confidence vote and a series of corruption scandals that have hampered the execution
of previously announced fiscal measures. We closed our overweight in the sol relative to the Brazilian real to lock in
some profits on the cross. We remain underweight local bonds which underperformed the benchmark after significant
selling by offshore investors. We continue to hold an overweight in hard currency bonds reflecting the strong relative
debt dynamics in the region.
7
Middle East, Commonwealth of Independent States (CIS) and South Africa
Georgia
Georgian CPI moved higher to just below the central bank target of 5% while second-quarter GDP softened to 5.2%.
We continue to expect a gradual moderation into year end and then a pick-up next year. Georgia Rail’s first-half
results showed a widening in EBITDA margins, despite a drop off in oil volumes. We are neutral Georgia’s dollar bonds
through a holding in Georgia Rail.
Israel
Low inflation and weak growth added impetus to the central bank’s desire for a weaker shekel, which sold off a further
3% over the month. Even so, this is unlikely to be enough to prevent a negative inflation reading in September. The
central bank kept rates at 0.25% but the minutes of the MPC meeting were dovish. We remain neutral the Israeli shekel.
Kazakhstan
The new Kazakh 10-year and 30-year dollar bonds attracted huge investors interest and cleared 25 and 30 basis
points lower than initial market guidance. We opted to stay on the sideline believing that it would cause a revaluation of
our overweight position held through quasi sovereign bonds, which it did. There is little appetite from the central bank
for another tenge devaluation but the currency’s appreciation against the Russian ruble is increasing the risk to our
overweight.
Russia
The Russian economy continues to struggle under the heavy weight of sanctions and geopolitical risks which are
causing significant capital outflows. The central bank has chosen to remain focused on its inflation-targeting framework
and thus did not substantially increase interventions in the foreign exchange market. As such, the ruble continued to
sell-off, heightening the risk to inflation itself, but somewhat mitigating the negative budgetary effects of a lower oil
price. We remain neutral all Russian assets (hard currency bonds, local bonds and the ruble) but are underweight the
quasi-sovereign bonds.
South Africa
On balance, the last month’s data has been poor again, with widening trade and budget deficits. Overall PMI did improve
slightly, although new orders did note, and the economy is still heading for c.1.5% GDP growth this year. The prospective
central bank governor, Lesetja Kganyago, is a good choice and points to policy continuity. We believe the current
profile of market rate hike expectations to be too aggressive and added shorter-dated bonds. We continue to hold an
underweight position in the rand (versus the Turkish lira) and an underweight exposure to South Africa’s dollar bonds.
Turkey
Despite confirmation of weak second-quarter growth of -0.5% quarter-on-quarter, the high frequency numbers have
since ticked up somewhat. The central bank remains between a rock and a hard place, with a need to keep rates on
hold at 8.25% due to political risks weighing on the lira. There was some relief with inflation surprising to the downside
as it fell to 8.9% during September. Syria, and specifically the northern town of Kobane, has become a complicated
issue for the government worried about a unilateral Turkish attack on IS eliciting a violent retribution. The dithering
has in turn incited protest from its Kurdish population. We built an overweight in the front end of the yield curve,
believing that central bank will be hard-pressed to hike rates amid such a weak growth environment, with base-effects
supporting disinflation at least until the second quarter of 2015. We continue to hold our overweight position in the lira
against the rand.
Ukraine
The ceasefire in eastern Ukraine remains fragile – some would argue it is non-existent in Donetsk, where there
is continued fighting for control of the airport. While rebels push for more independence for the region there are
continued efforts for a diplomatic solution at a higher level. The drop-off in economic output has been meaningful and
deposit withdrawals from the banking sector remain high. The central bank has enforced further measures to support
the weakening currency. Despite disruptions in the east, tax collections have been relatively strong. We are neutral
Ukraine’s dollar bonds and hold a small overweight in the hyrvnia.
8
Africa ex South Africa
Egypt
Egypt posted real GDP growth of 2.1% for fiscal year ended 30 June 2014. Rapid growth in manufacturing,
transportation and communication sectors was dragged down by continued contraction in the energy sector. High
frequency indicators point to an acceleration in real growth during the summer as industrial production improved to a
two-year high while August tourist arrivals posted their strongest figures since the 2011 revolution. On the balance of
payments side, Egypt’s situation is slightly more precarious as financing of a deteriorating current account deficit has
become almost wholly dependent on private and GCC transfers.
Kenya
In line with several other African economies, Kenya announced a revision to its GDP estimates resulting in a 25%
increase in GDP to US$55bn. Increased coverage was given to growing industries such as mobile money and informal
businesses. Stronger GDP growth was also met with a decline in inflation to 6.6% (from 8.1%) on the back of lower
fuel and food prices. Although recent news has been positive, we remain underweight the Kenyan Shilling relative to
the Ugandan Shilling as excess liquidity resulting from increased fiscal expenditure and the reluctance of the central
bank to raise rates should keep the Kenyan shilling under pressure.
Ghana
During the month, Ghana issued a US$1bn Eurobond clearing at a yield of 8.25%. The Eurobond provides temporary
respite with the real test being the commitment of government to follow through with a possible IMF program.
Meetings between the IMF, World Bank and Ghana will be completed during the first half of October. We took profit
on our overweight cedi position following a 15% rally in the currency as we expect seasonal currency pressures to
reassert themselves during the latter part of the year, while IMF execution risks remain high.
Nigeria
With elections looming early in 2015 the People’s Democratic Party moved to assert themselves as favourites by
confirming President Goodluck Johnathon as their only candidate for elections, while the opposition All Progressives
Congress party is yet to announce presidential candidates. This made it the first time since Nigeria’s return to
democracy that the PDP presidential candidate won’t have to contest in the primaries. On the economic side, GDP
growth was relatively robust at 6.5%, driven by manufacturing growth, but risks remain to the downside following
recent oil price weakness. The central bank decided to leave rates on hold, but have taken an increasingly hawkish
tone given recent naira volatility. We closed our naira overweight during the latter part of the month as lower oil
prices, below target oil production and the possibility of increased political noise as we move closer to elections have
balanced risks to the downside.
Uganda
Ugandan inflation eased further during the month with core inflation coming in at 2.0% (down from 3.1%). This was as
a result of a deflationary food environment and base effects from 2013 tariff hikes, which we expect to moderate in the
coming months. We remain overweight the Ugandan shilling relative to the Kenyan Shilling as we believe that the central
bank will continue to keep real rates high to maintain currency stability while running an expansionary fiscal program.
Zambia
Uncertainty around the health of President Michael Sata, resolution of exporters VAT repayments and weak Chinese
growth all weighed on the local unit over the month. President Sata failed to give his scheduled address at annual UN
meetings due to illness and was subsequently flown back to Zambia where uncertainty around a succession and a
lack of communication has encouraged the local succession rumour mill. The ministry of finance made another U-Turn
regarding the repayment of $600m of VAT refunds to exporters, when the initial decision to repay was followed by an
announcement of a delay to further study the impact of repayment. We expect clarity on VAT repayments when the
budget is announced on the 10 October 2014, and with recent pressure from global mining houses to cut investment
and jobs in the country due to the VAT issue, we expect the government to acquiesce and repay in a staggered
fashion. We reduced our overweight over the month after a strong run but remain positive given IMF involvement and
the high yield on offer.
9
Asia
China
Economic data took a turn for the worse last month but, with the latest PMI stabilising, growth is not expected to
capitulate from here. The property sector remains a headwind to growth, offset somewhat by the services sector and
strong external demand resulting in impressive trade numbers. We expect this theme to continue, with the strong trade
balances likely to keep the renminbi on a relatively strong trend. We retain our overweight in the currency.
India
Inflationary pressures are expected to moderate over the next couple of months as the monsoon rains pick up.
Nevertheless, the central bank kept rates on hold this month, sighting risks to the upside on its medium-term inflation
targets. S&P upgraded its outlook to ‘Stable’ from ‘Negative’, alleviating fears of a potential downgrade to junk status.
We increased our overweight in the rupee.
Indonesia
Politics made an unexpected turn for the worse. The opposition coalition led by Prabowo has gained strength and is
making life difficult for President-elect Joko Widodo. We still expect a strong economic team to be named and fuel
hikes to be pushed through, but it looks like it will be difficult for Widodo to conduct more reforms until he gains more
political support. Based on modest fundamental improvements, we maintain a small overweight in the currency as well
as hard currency bonds, but are monitoring closely.
Malaysia
The fuel subsidy cuts were a positive surprise as markets were beginning to worry about the commitment to fiscal
consolidation. Based on these developments, we remain comfortable with our small overweight position in the ringgit. We
remain neutral local bonds which are close to fair value in our view, especially as inflation will remain somewhat elevated.
Philippines
he central bank hiked interest rates again and with a slight drop in inflation during September, it clearly shows they
have moved ahead of the curve for now. While the balance of payments position remains strong, with very low
implied interest rates on currency forwards and valuations around fair value, we remain neutral the peso. We remain
underweight hard currency bonds on expensive valuations.
Singapore
Economic data remains mixed. We expect no change in the policy settings at the central bank’s October meeting, but
do expect they will be most comfortable with the currency in the lower end of the band given the challenges facing
some export sectors, especially in electronics. We remain overweight local bonds and underweight the currency.
South Korea
Policymakers have been voicing their concerns over the continued appreciation of the won vis-à-vis the Japanese yen,
and the impact this has on Korean export competitiveness. Based on this dynamic, we closed our overweight in the
won and moved to an underweight position later in the month. The bond market has priced in a high chance of further
rate cuts, hurting our underweight position in bonds; we think the risk is that the central bank stays on hold as growth
continues to recover moderately, hence we retain our position.
Sri Lanka
While exports continue to perform well, import growth has picked up meaningfully over the last couple of months,
resulting in a notable widening of the trade balance. Given the change in this dynamic, we took profits on our
overweight in hard currency debt as spreads continued to outperform the benchmark and similarly rated peers.
10
Taiwan
Data has turned a little less positive over the month, with a notable drop in the PMI and trade data disappointing. A big
drop in inflation last month means the central bank is unlikely to allow the Taiwan dollar to appreciate from here, and there
is a risk that Occupy Central protests could lead to further unrest in Taiwan. We remain underweight the Taiwan dollar.
Thailand
GDP growth and imports are rebounding slowly. The military government is increasing spending, mostly on
infrastructure, but broadly-speaking is applying fiscally prudent principles. The central bank seems clearly on hold,
allowing little room for bonds to rally, and as such we remain underweight. With exports still weak, we believe the baht
will underperform relative to its peers.
Corporate bonds
Focus of the Month: Oil E&P companies
In the JPMorgan CEMBI index, 8.5% of issuers are oil exploration and production companies. The headline oil prices
have been declining recently with Brent down 20% YTD. The oil prices started declining in early July, and, as a result,
we should see the first real impact on company financials in third-quarter results, which will be released over the
coming weeks. Our in-house financial modelling allows us to estimate the impact of the downward moves in oil prices
on the issuer’s credit quality ahead of the results.
Initially, we consider the different oil benchmarks that our companies follow. Brent is the most liquid oil price
benchmark, but other benchmarks also represent a meaningful portion of the oil market. Over the last three months,
Brent, Dubai benchmark and WTI have declined in line by 16-18%.
The oil benchmarks are usually quoted in U.S. dollars, but emerging market oil producers face most of their operating
cost and a substantial portion of their capital expenditure in local currencies. With local currencies weaker in the third
quarter vis-à-vis USD, the oil price impact on the bottom line of emerging market oil companies will be less than the
USD-denominated oil prices suggest, because a substantial proportion of costs is local currency linked.
For example, most oil producers from EM countries have a 4-10% pricing mitigant due to EM currency devaluation,
with the extreme example being rouble denominated Brent oil, which is down only 6% since June 30th. In addition to
oil prices, we focus on the volume growth for the oil producers. We expect our selected high yield oil credits to deliver
5-15% production growth on a year-on-year basis. This should mitigate the recent decline in oil prices. Our portfolio
companies are also positioned in the lowest half of the oil cost curve, and as such enjoy a substantial cushion unlike
the higher cost producers.
Overall, at the current oil prices, we expect some increase in leverage and deterioration in cash flows among emerging
market oil producers. However, the oil price decline should be mitigated by local currency weakness, production
growth and a competitive positioning on the cost curve. We continue to monitor the demand-supply dynamics in the
oil market that ultimately drives the oil price. Should oil prices adjust further, we will be recalibrating our positioning in
the sector.
Sector-by-sector
Commodity
Emerging market (EM) financial bonds retreated slightly during September. Brazilian banks were the biggest
underperformers as election results surprised the market negatively, while Russian banks recovered from the previous
month’s low levels and outperformed. The new issue market was busy after the summer holidays, and continued to be
dominated by Basel III-compliant subordinated issuances. We remain underweight Russia and increased positions in
selective high yield names with stable fundamentals and attractive valuations.
Financials
Emerging market (EM) financial bonds retreated slightly during September. Brazilian banks were the biggest
underperformers as election results surprised the market negatively, while Russian banks recovered from the previous
month’s low levels and outperformed. The new issue market was busy after the summer holidays, and continued to be
dominated by Basel III-compliant subordinated issuances. We remain underweight Russia and increased positions in
selective high yield names with stable fundamentals and attractive valuations.
11
Heavy Industrial
We remain overweight industrials in Latin America, with a bias towards investment grade companies. We expect Latin
American infrastructure companies to benefit from state sponsorship through infrastructure spending, while many
Asian industrials have been impacted by weaker demand from property companies in China and slower GDP growth.
Real Estate
The real estate sector had a reasonable month in September. China’s market remained weak; prices recorded a
further decline in August, though volumes rose. However, bonds were supported by fresh stimulus measures from the
government, notably the relaxation of restrictions on second-time home buyers and the injection of capital into the
top four state-owned enterprise (SOE) banks to facilitate mortgage lending. Longer-dated bonds were re-priced for
expectations of higher US interest rates. In Indonesia, the bigger developers continued to show improving pre-sales.
TMT
September was a weak month for the TMT index. Large high yield telecoms companies in Latin America (LATAM) were
sold by US accounts taking profit and reducing exposure to off-index investments, which had a negative impact on
relative performance due to our overweight in some of these credits. However, this was offset by our investments in
Asian investment grade credits, which held up well.
Consumer
It was another tough month for the Agricultural credits, with further weakness from Mriya Agro Holding on its
restructuring plans infecting other Ukrainian agricultural names. In LATAM, concerns over the headwinds from
depressed sugar prices pushed yields wider in the highly-levered sugar and ethanol players. While we continue to
watch the sector closely – as we are concerned over economic instability pressuring the real consumers –, we take
comfort from our maintained exposure to the industry through the more geographically-diverse players, such as those
involved in the global protein sector.
Utilities
With Brazilian election polls suggesting a tight race, concerns that the incumbent president, Dilma Rousseff, would
stay in power drove yields wider in the state controlled utilities. The increasing degree of state intervention experienced
by such firms during Rousseff’s current term has meant that investors regard them as offering limited profitability.
We prefer to maintain the bulk of our utility exposure in corporates which benefit from strong governmental support
through clear regulation, allowing the corporates to invest with a clear grasp on future profitability and thus maintaining
stronger standalone credit fundamentals.
12
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