1. Art and Diseño

Emerging Market Debt:
Fear Creates Opportunities But Pick Your Spots
January 2015
STEVE COOK
Managing Director, Senior
Corporate Portfolio Manager,
Emerging Markets Fixed Income
A cocktail of uninspiring emerging market (EM) growth outlook and a strong US
dollar means hard currency bonds are set to outperform local currency in 2015
even though the starting point is much more attractive for the latter. In an
environment of moderately increasing US Treasury rates, the lower duration
and higher spread cushion of EM corporates may help them to outperform
ANDERS FAERGEMANN
Managing Director, Senior
Sovereign Portfolio Manager,
Emerging Markets Fixed Income
NATASHA SMIRNOVA
Vice President,
Product Specialist,
Emerging Markets Fixed Income
sovereigns where uncertainty over a number of special situations, including
Ukraine, Venezuela, Argentina as well as exposure of some exporting nations,
particularly in Africa, to lower commodity prices may weigh on returns.
Ultimately though, getting China, Brazil and Russia developments right will be
the biggest sway factor to return expectations and outperformance.
Starting With Low Expectations
In many ways 2015 does not offer a lot of promise for emerging markets.
However, if we reflect on the outcome of 2014, that should leave us with a lot
of hope. The main theme for 2015 should be structural reform but apart
from Mexico, India and, we hope, Indonesia, the starting point for the
market’s expectations for significant reforms is very low – leaving room for
plenty of upside surprises.
Countries such as India, Indonesia and Turkey saw considerable
improvements in their current accounts. Although further improvements
are needed, the market has already turned its focus to other issues, partly
driven by the fact that inflows into emerging markets have been led by
institutional investors with longer investment horizons than the retaildriven outflows of 2013. We expect this trend to continue in 2015 as the
post-election political situation has improved in many EM countries. The
reform drive and its relative success will determine each country’s
attractiveness to foreign investors.
India, and, to an even larger extent, Mexico have taken the lead in this
particular race, although we do not underestimate the desire of new
Indonesian President Jokowi to ruffle a few establishment feathers. Turkey
is not on the list of potential reformers but Brazil has been added. The new
economics team is yet to convince investors, but the first indication of policy
moves towards adjusting deteriorating fiscal accounts are encouraging,
much more is expected though. Controversially, even Russia may be pushed
into the reform mode to diversify away from the oil sector that has
maintained a steady 20-25% share of GDP over the last decade.
External Factors To Drive Performance
The external backdrop is likely to remain the main driver of EM returns. Yet,
it has become increasingly clear that EM investors are able to distinguish
This material must be read in conjunction with the
disclosure statement.
Any views represent the opinion of the manager and are subject to change. Past Performance is not indicative of
future results.
Figure 1
EM Currencies Have Weakened Substantially
But Will Offer Value As Growth Recovers
10.00
127
9.00
8.00
117
7.00
6.00
107
Figure 2
70%
97
3.00
2.00
87
1.00
77
0.00
0303 04 04 05 05 06 06 0707 08 08 09 09 10 10 11 11 1212 13 13 1414 1515 1616
EM GDP growth, yoy % (right scale)
EM FX Index*
Index weight of net oil
exporting/importing countries
60%
44.70%
36.90%
40%
30%
20%
64.00%
55.20%
50%
5.00
4.00
Net Oil Importers Dominate EM Universe
30.50%
14.30%
18.50%
17.80%
18.20%
10%
0%
exporters neutral importers exporters neutral importers exporters neutral importers
EM sov. credit
EM corp/quasi credit
EM local
Source: J.P. Morgan, The IMF, WEO update. Data as of January 2015.
Source: Barclays, The EM Quarterly. Data as of December 2014.
between unjustified fears of a total meltdown related to
the potential interest rate normalisation in the US, which
mired EM returns in 2013 and the idiosyncratic country
flare-ups that dominated EM returns in 2014.
recovers more widely and is matched by the potential for
Last year’s recovery by EM hard currency bonds was
nothing short of remarkable, even though it was marred
by a bout of risk aversion in December. The bounce-back
may effectively cap any potential for another surprise
outperformance in 2015. Instead, the focus will be on
alpha generation from country selection and on timing a
re-entry into local bond markets that offer attractive
yields but volatile exchange rates.
economic reform, we expect more demand for EM assets
and EM currencies. This may happen in the second half of
2015 or we may have to wait for firmer evidence in 2016.
Lower Commodity Prices ≠ EM Crisis
Downside risks remain centred around the inability of the
Chinese economy to grow above 7% without targeted
policy measures and that a number of EM countries will
lose a reliable anchor for their commodity exports,
leading to a more secular drop in commodity prices. Even
though the impact of lower commodity prices on EM
growth is positive on aggregate as net oil importers
US dollar strength, driven by divergence in forces of
dominate the universe (Figure 2), it will polarise
monetary policy normalisation between the US and the
economies. The 50% drop in oil prices since the middle of
last year will push some oil producers into recession, but
it will create large savings for oil importers. These will be
largest in emerging Asia and Central and Eastern Europe,
which leaves these regions poised for significant positive
terms of trade effects. A strong disinflationary
environment will be pervasive across all EM economies,
allowing centrals banks more room to accommodate
weaker exchange rates. Ultimately, EM countries will, at
large, need to substitute some of the reliance on external
support with a more focused drive towards structural reform.
rest of the world since late summer, may well continue
into 2015 boosting with it the USD-based EM spread
products unless the Fed starts paying more attention to
the frailty of the global economic recovery or the currency
adjustment among EM countries (Figure 1) start to pay
dividends in the form of improved terms of trade.
Attractive Yet Scary FX
The exchange rates of a number of large EM countries
have fallen by 25-40% versus their 2012 averages - the
sort of adjustment economists would consider appropriate
in a currency crisis. Thankfully, the falls have occurred in
an orderly fashion as part of a world of flexible exchange
rates and independent central banks. We anticipate a
boost to export growth from the weaker currencies with a
6-9 months lag, eventually enabling these currencies to
recover some lost ground. Once economic growth
2
Corporates To Shine
In the EM corporates universe, 2014 was another relatively
predictable year in terms of trends with fundamentals
remaining stable, technicals and supply remaining strong
with a third straight year of record gross issuance of over
US $300 billion. Total returns exceeded all initial
expectations even as December proved a rough month as
risk aversion increased on the back of the sharp falls in
returns is an inexact science. It is a tough ask to develop
energy prices and currency weakness. The broad
strong convictions about return expectations for a
benchmark spreads, at over 430bp versus the US
complex asset class which is 70% investment grade and
Treasury, are now trading wider that during the 2013 EM
30% high yield, spread across 49 countries, over 500
confidence crisis and cheapened up versus both
issuers and more than 40 industry sectors.
developed markets investment grade and high yield
offering, on average, 180bp in spread pickup in the BBB
Certain aspects are clear, the EM corporate default rates
category and 250bp in the BBs, both are pretty much at
will remain relatively benign, spreads are still attractive
the top of their five-year trading ranges. With the larger
versus developed market, investor base continues to
spread cushion and lower duration versus its sovereign
broaden and deepen, the EM versus DM growth
peers EM corporates may well claim the top spot in EMD
differential is still in place, and the asset class has a low
returns in 2015, barring the repeat of the last year’s
sensitivity to US Treasuries. Consequently, we expect
scenario where longer-duration sovereign assets were
demand for EM corporates to remain as strong as it has
major beneficiaries of lower US yields, not quite what was
been over the past three years, providing the search for
anticipated at the start of the year.
high quality risk assets continues and US Treasury rates
creep higher, rather than suddenly spike aggressively. We
The market will re-focus on fundamentals once the dust
also anticipate corporates to continue decorrelating from
settles. We expect to see a recovery, although it may start
EM sovereigns and to converge more with its developed
slowly as investors remain rather cautious. From the
market credit peers. As the global investor base searches
corporate fundamentals perspective, we expect recent
for global multi-sector solutions, we expect EM
generic trends and new issuance levels to be maintained
corporates to be viewed as an integral part of the global
but, as always, forecasting of EM corporate supply and
fixed income.
Disclosure Statement
16 June 2014
1007044
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