Flash comment - Emerging Market Debt

The PBOC’s move

The decision of the People’s Bank of China (PBOC) to move to a more flexible FX regime on August 11th resulted in a 2.8% CNY devaluation and triggered a significant global market correction which is still ongoing. The change of FX regime is not surprising per se as the CNY is practically the only emerging market currency to have appreciated since mid-2011, when the strong USD trend began. The timing was surprising and the PBOC communication introduced lots of uncertainty with respect to the rationale of the move as well as the pace of the devaluation.

This also happened at a time when the Chinese authorities were struggling to stem the decline in the Chinese equity market and manage a smooth downward adjustment in growth rates.

Elevated risks regarding China growth and monetary policy also led to an acceleration of the commodity correction (particularly in oil, Brent was down 16.5% in August*) as global demand for commodities remains weak and most commodity markets remain over-supplied.

Main consequences for the EM markets

EM markets led the correction as these had the highest exposure to the Chinese slowdown, commodity and Fed-tightening risks. EMFX (based on the GBI-EM GD FX return) is down close to 4.4% MTD and 14.0% YTD*, which, despite the positive LC rate returns MTD and YTD (0.4% and 4.0%*), led to deeply negative LC index returns in USD un-hedged terms: -5.8% MTD and -12.7% YTD*.

The RUB (-15.2%), COP (11.1%) and MYR (-10.0%) commodity exporter currencies were the worst monthly performers*. EM central banks managing currency pegs (Vietnam and Kazakhstan) were also forced to take action and devalue their currencies, by 3% and 25% respectively. Pressure continues to build on other pegged currencies like NGN and EGP to proceed with sizeable one-off FX devaluations in the near term.

EM sovereign spreads have widened by 62bps to 429bps* (see Chart 3) on the month and are close to post-Global Finance crisis’ (GFC) highs of Sep-11 (441bps), Jun-12 (426bps) and Dec-14 (416bps). The EM sovereign yield has breached 6.21% (up by 20bps on the month) and is closing in on post-GFC highs – Jan-10 (6.6%), May-10 (6.6%), Aug-13 (6.2%) and Jan-14 (6.1%). Generally, commodity exporter credits and FX were the worst hit, with Africa and Latam underperforming and Asia, Europe and the Middle East outperforming in the Hard Currency (HC) sovereign space. In the Local Currency (LC) space, China trade and FX linkages and the risk of further competitive devaluations drove a broad-based FX correction which led to an Asia, in addition to a commodity-heavy Latam, underperformance.

IS THE ATTRACTIVENESS OF EM DEBT IN QUESTION?

EM sovereign spreads are at multi-year highs and EMFX are sinking to new record lows, suggesting a good portion of the cyclical and structural EM risks are already priced in. EM valuations are, thus, already attractive from a historical perspective.

Emerging Market fundamentals

EM fundamentals are mixed. The EM universe contains both commodity exporters (concentrated in Latam and Africa) and importers (concentrated in Eastern Europe) whose fundamentals react differently to the risks of a China hard landing and the related ‘end of the commodity super-cycle’. For example, oil exporters represent only 25% of the EM sovereign index, which suggests that most of the index countries are benefiting from the lower oil prices. Debt sustainability is not an issue for the overall EM sovereign universe as public-debt-to-GDP levels are still, on average, 40% relative to the DMs’ 90% (IMF data).

EM political risks

EM political risks are also mixed. Risk is elevated in countries facing elections like Turkey, Argentina and Venezuela, and others with ongoing corruption scandals like Brazil and Malaysia that might trigger further political volatility. Eastern European credits, though, face limited political uncertainties and are benefiting from strong institutions anchored to EU ones.

The case of the Fed hiking cycle

The Fed hiking cycle has had a differentiated impact on the EM universe. Higher US rates could trigger an unwinding of the EM carry trade and affect credits with high external imbalances, low FX reserve cushions and inadequate structural reform policies. Since 2013, when ‘taper tantrum’ differentiated between twin deficit credits and others, India has largely exited the vulnerablecountry category by implementing significant structural reforms and engineering fiscal consolidation and the reduction of its current-account deficit. Indonesian policymakers have also implemented reforms targeted at improving government finances, although implementation has been less impressive. Brazil, Turkey and South Africa have continued to experience a deterioration of fundamentals as policymakers failed to take action and resolve external imbalances.

Are EM Central Banks well equipped to face another crisis?

EM policymakers are also better prepared relative to other EM crisis episodes as:

• EMFX are, generally, freely floating and central bankers have not drawn down FX reserve cushions to support currency levels allowing significant FX adjustment since 2011;
• Fiscal and monetary policy frameworks are, generally, more solid relative to the 1990s and 2000s;
• EM economies are richer and EM policymakers have, generally, implemented orthodox macro-economic management policies and created stronger institutions over the past 30 years;
• The largest EM economies have developed liquid and well-functioning local markets and dedicated local investor bases that provide an alternative to international investors for funding government deficits.

What the technical indicators tell us

The EM bond technical picture is mixed. Investor positioning and cash levels are supportive as dedicated EM investors have largely prepositioned for a Fed hike and have very low exposure to EMFX and local-rate markets. Flows into EMD since the taper tantrum in 2013 have been subdued and the majority of the flows have gone into HC, which offers a more defensive exposure to the EMs (see Charts 5 and 6).

The risk of further outflows is elevated as, historically, flows and returns are positively correlated and higher frequency data flows suggest that outflows from the asset class have, so far, been limited.

OUR CURRENT POSITIONING

We remain defensively positioned across LC and HC strategies. Our investment strategies continue to focus on differentiation and favour exposure to attractive relative value opportunities.

• In the LC strategy, we are very underweight EMFX and EM local rates and long US Dollar (23.4%^*) and HC-denominated assets.
• In the HC strategy, we are overweight Eastern Europe via Hungary and Croatia, underweight vulnerable credits like Brazil, Turkey, Russia and South Africa, and have a balanced and selective positioning to commodity exporters with the overweights in either stronger credits or in credits where valuations already reflect risks offset by underweights in credits with weaker relative value metrics.

The Emerging Markets Team