Emerging Markets Debt Indicator - Amazon Web Services

Emerging Markets Debt
Month ending 31 October 2014
Market Background
Emerging market debt bounced back in October following the
previous month’s weakness. The minutes from the September
Federal Reserve (Fed) meeting spooked markets, resulting in
the 10-year Treasury yield rallying through 2%. Treasuries
have since steadily sold off on the back of continued strength
in domestic economic data, while the Fed announced the end
of its quantitative easing (QE) programme with the final US$15
billion taper. The impact on global liquidity conditions was
partially offset by the Bank of Japan’s decision to step up its
QE programme.
Chinese data showed signs of stabilisation despite annualised
GDP slipping to levels not seen since 2009. Third-quarter
GDP fell to 7.3% versus 7.5% the previous quarter, but
China’s leaders suggested it was in line with the ‘new normal’
as the country’s growth model transforms to one driven by
consumer spending. Elsewhere in Asia, South Korea’s central
bank cut rates by 25 basis points after revising down their
forecasts for both economic growth and inflation.
In Latin America, Brazilian markets were rattled by incumbent
President Dilma Rousseff’s narrow re-election victory
towards the end of the month. Although a surprise rate hike
helped support the currency towards the end of the month.
In Chile, the central bank cut rates for the fourth straight
month after concerns over weaker growth. However,
persistently high inflation means this is likely to be the end of
its year-long easing cycle. Russia was once again a notable
laggard over the month as geopolitical risks remain. A
weaker ruble and ban on western food imports has kept
inflation stubbornly higher prompting the Russian central
bank to raise interest rates 150 basis points to 9.5%.
Local currency bonds rallied 1.56% in October, as measured
by the JP Morgan GBI-EM Global Diversified Index. Bonds
returned 1.62%, while currencies were marginally down
0.06%. The Chilean peso was the best performing currency
in the index as the central bank signalled an end to its easing
cycle as inflation ticks higher. The Turkish lira and South
African rand were also relatively stronger. By contrast, the
principal laggard was the Russian ruble, despite the central
bank’s attempts to defend the currency. The Colombian
peso and Polish zloty were also weak.Turkey was the top
performing bond market with the central bank modestly
more dovish on the inflation outlook given lower commodity
prices. Indonesian and South African bonds were also
relatively strong. Russia was the weakest bond market as
capital outflows continued. Nigerian bonds also came under
pressure with falling oil prices a notable headwind.
Hard currency bonds, as measured by the JP Morgan EMBI
Global Diversified Index, fell by 1.71%. The index yield ended
somewhat lower at 5.22% while spreads over US Treasuries
fell slightly to 296 basis points. The best performing hard
currency bond market was Turkey, followed by the Dominican
Republic and Ukraine. By contrast, the worst performers
were Venezuela, Iraq and Senegal.
Corporate bonds, as measured by the JP Morgan CEMBI
Broad Diversified Index, rose 0.91% with spreads rising
slightly to 308 basis points. Investment grade bonds (1.02%)
outperformed high yield bonds (0.68%). The top performing
sector was TMT with infrastructure and utilities also
outperforming. By contrast, metals & mining and oil & gas
both lagged the overall index. Regionally, Latin America
performed well, while Africa was the principal laggard.
The picture for global growth remains mixed. In developed
markets, we continue to witness a growing disparity between
a relatively strong recovery in the US on the one hand and
weakness in Europe and Japan on the other. Meanwhile,
Chinese data flow remains on a moderating trajectory,
although growth should stay between 7 and 7.5% for this
year. As a result, the growth fortunes of individual emerging
markets will depend on the extent and nature of their
exposure to these large economies.
Emerging market inflation continues to moderate on the back
of depressed food and energy prices and this dynamic is
likely to remain over the coming months. This should help
to mitigate the impact of pass-through from the stronger
US dollar, although we are cognisant of the threat of deflation
in some markets (such as Hungary) and accelerating inflation
in others such as Russia.
Portfolio flows into emerging market debt have been
modestly stronger in recent weeks. We also believe the
composition of flows has come more from institutional clients
which tends to be more longer term investment, as opposed
to retail and cross-over investors who were the big sellers
of emerging markets last year. We still feel global investors,
particularly US institutional investors, remain structurally
under-allocated to emerging markets which will provide
a tailwind for flows over the medium term.
Overall, we believe global growth patterns, positioning within
the economic cycle and the external financing requirements
of individual emerging market economies will remain the key
determinants of individual market performance.
This communication is only for professional investors and professional financial advisors. It is
not to be distributed to the public or within a country where such distribution would be contrary
to applicable law or regulations.
Topic of the month: Growing up — emerging market central bank credibility
underpins local bond markets
Taking a step back from short-term events, longer-term economic and market trends are becoming increasingly apparent in
emerging market (EM) local currency debt markets, which have important implications for how we can think about structuring
our portfolio going forwards. Currency weakness in emerging markets has, historically, been linked to rising bond yields in
these markets. However, we believe this relationship is not as strong as it once was. The Asian financial crisis prompted many
EMs to take key steps to reform macroeconomic policy, including enhancing central bank credibility in an effort to make their
economies more resilient to external shocks. The evolution of central bank policy and deepening of domestic bond markets
means that, even in a rising dollar environment, many EM central banks are now relatively free to pursue monetary policy
suitable for their domestic economies. As such, it is possible to have positive gains in local currency bond markets even in
a period of modest currency weakness.
Historical context
Historically, monetary policy in emerging markets was hostage to external shocks and policy shifts in developed markets,
particularly in the US. Moreover, the dynamics of the US dollar and the euro have also played their part in influencing policy
decisions. Regardless of domestic inflation and growth trajectories, a stronger US dollar put pressure on the domestic currency,
feeding fears of imported inflation, hurting the bond market and driving further outflows and currency weakness. In the end,
central banks had to hike interest rates, despite often weaker domestic conditions. If the local currency had been pegged, then
these pegs often broke under the pressure and there was widespread financial distress, and in some cases, default.
This was particularly manifest during the 1997-98 Asian financial crisis. Although the reasons for the crisis were profuse, dollar
strength versus EM currencies and the prevalence of ‘original sin’ – the proportion of outstanding sovereign debt denominated in
foreign currencies (typically US dollar) – exacerbated the crisis. More expensive external debt repayments reinforced further
currency weakness and outflows. As a result of the crisis, currencies (such as the pegged Thai baht), collapsed and interest rates
were dramatically hiked in a number of countries, including Indonesia. Chart 1 outlines the Bank of Indonesia’s monetary policy
tightening imposed during the crisis with interest rates soaring to extreme levels. The severe sell-off in regional currencies and
assets led to economic depression and political instability in a number of countries.
Chart 1 Indonesia interest rates versus the US dollar index during the 1997-98 Asian financial crisis
Jan 90
Jan 91
Jan 92
Jan 93
Jan 94
Jan 95
Jan 96
Jan 97
Jan 98
Jan 99
Jan 00
Jan 01
Jan 02
Jan 03
US dollar index
Bank of Indonesia: benchmark interest rate
Source: Bloomberg
The chaotic events that unfolded during the Asian financial crisis can be contrasted with what Harvard economist Ricardo
Hausmann has referred to as the “mythical” status of Australia back in the 1990s.1 Despite having a small, open economy
with commodity-intensive exports, Australia was able to set domestic monetary policy relatively free from external
At the time, this was unthinkable for EMs.
Reserve Bank of Australia Conference,1999. Transcript: http://www.rba.gov.au/publications/confs/1999/hausmann-disc.html
What has changed?
However, in the years since the Asian financial crisis, emerging markets have taken significant steps in addressing their
policy limitations to provide greater resilience in times of stress. It is no longer the case that EM currency weakness is
necessarily associated with rising domestic interest rates. Those EMs, such as Chile and South Korea, that adequately
reformed can increasingly set policy rates relatively unconstrained by external factors. (This has not been the case for all
emerging markets. For example, Brazil, Russia, South Africa and Turkey have been forced to raise interest rates in the past
few months in a more traditional manner to prop up the value of their currencies and stem outflows).
Firstly, there has been rapid growth in foreign exchange reserves, which has allowed many emerging markets to smooth currency
volatility and ensure plentiful supply of foreign exchange in times of stress. There has also been a significant reduction in ‘original
sin’, which has reduced dependency on US monetary policy and the risks arising from significant dollar appreciation.2
Both of these well-documented developments have been underpinned by a fundamental shift towards greater credibility in
EM central bank policy through greater central bank independence and explicit mandates to curb inflation.
The credibility of central banks is crucial because it anchors inflation expectations, turning a self-fulfilling problem into a
self-fulfilling positive cycle. Thus domestic economic agents’ price-setting behaviour becomes less affected by exchange
rate fluctuations. So in periods of moderate currency weakness, domestic economic agents do not expect a sustained rise
in inflation, and so this self-fulfilling behaviour helps to keep a lid on inflation. In the current environment, this supports
disinflation from lower commodity prices despite the strengthening dollar. If economic agents believe the central bank has
the means and the willingness to fight inflation as and when it arises, then they will view interest rate cuts and modest
currency weakness as a natural outcome of disinflation. Domestic and foreign investors will therefore look to buy bonds
(possibly on a currency-hedged basis) if they believe inflation is falling, which is the case today across many EMs today.
Indeed, we have seen great strides in central bank credibility in a number of countries over the last 15 years since the 1990s
crises 3. This has resulted in more credible monetary policy. For instance, over the periods 2007-8, and again in 2011-2013, a
number of central banks had to cope with high inflation at the same time as a deterioration in growth prospects. Confronted
with this spectre of ‘stagflation’, central bankers with sufficient independence and long-sightedness had the room to hike
interest rates to combat inflation before it spiralled. More recently, central bankers in India and Indonesia focused on their
inflation mandates and raised interest rates to moderate price growth despite the lacklustre pace of economic expansion.
Where central bank credibility was already established in the early 2000s, it has allowed dovish monetary policy in a number of
markets recently despite dollar strength. Chart 2 below shows the relationship between the key benchmark interest rates for Israel,
South Korea, Mexico and Poland versus the US dollar. As the chart shows, since the first quarter of 2011 these central banks have
been implementing monetary policy easing while the US dollar has been strengthening. Even during the latest sharp correction in
the US dollar we have seen rate cuts in Poland, Korea and Israel as their central banks try to reignite economic growth.
Chart 2: Benchmark interest rates in selected EMs (LHS) versus the US dollar index (RHS)
Jan 11
Jan 12
Jan 13
Jan 14
US dollar index
Source: Bloomberg
Although it should be noted that emerging market corporates have issued considerable amounts of hard currency debt.
See IMF working paper WP/06/228. ‘Measures of central bank autonomy: empirical evidence for OECD, Developing, and emerging market
economies’ by Arnone, Laurens and Segalotto.
Similarly, chart 3 highlights the notable fall in EM bond yields even as the dollar has strengthened. Of note, while there was
an inevitable rise in EM yields during the ‘taper tantrum’ the gap between the two has widened once more in recent months.
Despite the prospect of US interest rate hikes in the coming months and a significantly stronger US dollar, bond yields in
these emerging markets have fallen over the past few months – with bond yields falling in tandem with easing in South Korea
and Poland.
Chart 3: Selected EM 10-year yields versus the US dollar over past five years
Nov 2009
US dollar index
Nov 2010
Nov 2011
Nov 2012
Nov 2013
Nov 2014
Source: Bloomberg
The result of these developments is a changing environment for emerging market debt, where many (although not all)
emerging markets can tolerate periods of modest currency weakness accompanied by disinflation and positive returns in
local bond markets. Specific market returns will be dependent on the quality of institutions, credibility of monetary policy,
inflation outlook and the ownership structure of the domestic debt market.
Our scorecard process considers all these factors and this allows us to distinguish those countries which can achieve the
positive feedback loop described above. In the team, each regional specialist is required to consistently score the quality of
not only short-term monetary and fiscal policymaking decisions, but the longer-term socioeconomic and governance factors
which can underpin the kind of changes in central bank credibility we have discussed. These scores are consistent across
countries and time horizons, allowing us to take advantage of such trends in our portfolio decisions.
EMD country and sector analysis
For detailed analysis please click here.
Important information
This document is not for general public distribution. If you are a private investor and receive it as part of a general circulation, please contact us
at +44 207 597 1900.
The information discusses general market activity or industry trends and should not be construed as investment advice. The economic and
market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be
affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no
assurance that these forecasts will be achieved. Investors are not certain to make profits; losses may be made. Past performance should not
be seen as a guide to the future.
The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly
held but are not guaranteed and should not be relied upon.
This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale
and is not a buy, sell or hold recommendation for any particular investment.
In the US, this communication should only be read by institutional investors, professional financial advisors and, at their exclusive discretion,
their eligible clients. It must not be distributed to US Persons apart from the aforementioned recipients.
In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001).
All data sourced from Bloomberg and Investec Asset Management. Outside the US, telephone calls may be recorded for training and quality
assurance purposes.
Issued by Investec Asset Management.
Level 23, The Chifley Tower
2 Chifley Square
Sydney, NSW 2000
Telephone: +61 2 9293 6257
Facsimile: +61 2 9293 2429
100 Robert Mugabe Avenue
Office 1, Ground Floor
Heritage Square Building
Telephone: +264 (61) 389 500
Facsimile: +264 (61) 249 689
Woolgate Exchange
25 Basinghall Street
London, EC2V 5HA
Telephone: +44 (0)20 7597 1900
Facsimile: +44 (0)20 7597 1919
666 5th Avenue, 37th Floor
New York, NY10103
US Toll Free: +1 800 434 5623
Telephone: +1 917 206 5179
Facsimile: +1 917 206 5155
Plot 64511, Unit 5
Fairgrounds, Gaborone
Telephone: +267 318 0112
Facsimile: +267 318 0114
PO Box 250, St Peter Port
Guernsey, GY1 3QH
Telephone: +44 (0)1481 710 404
Facsimile:+44 (0)1481 712 065
Woolgate Exchange
25 Basinghall Street
London, EC2V 5HA
Telephone: +44 (0)20 7597 1999
Facsimile: +44 (0)20 7597 1919
19849 – 11/14
Suites 2602-06, Tower 2
The Gateway, Harbour City
Tsim Sha Tsui, Kowloon
Hong Kong
Telephone: +852 2861 6888
Facsimile: +852 2861 6861
36 Hans Strijdom Avenue
Foreshore, Cape Town 8001
Telephone: +27 (0)21 416 2000
Facsimile: +27 (0)21 416 2001
One Fullerton #02-01
1 Fullerton Road
Singapore, 049213
Telephone: +65 6832 5052
Unit C, 49F, Taipei 101 Tower
No.7, Section 5, Xin Yi Road
Taipei 110, Taiwan
Telephone: +886 2 8101 0800
Facsimile: +886 2 8101 0900