27 JAN

2017

Diliana Deltcheva, Fixed Income, Topics

Investing in emerging market debt in 2017

The world appears to have become a less certain place. Brexit, the US elections, upcoming European elections and geopolitical concerns have shattered perceptions about the world order.

However, emerging markets enter this period of elevated uncertainty with strong fundamentals. We see growth momentum, relatively low fiscal and external sector imbalances, low inflation, decent forex reserve cushions and room for fiscal and monetary policy to react to external events.

EM bond valuations appear stretched

EM bond valuations appear stretched  near term but continue to be attractive in the medium term. These solid fundamentals have attracted bond investors. The “search for yield” dynamic that gathered speed after Brexit and as the BoJ and ECB extended their accommodative policies, inflated EM bond prices. In the near term, EM bond valuations appear extended just as the US Fed is likely to turn more hawkish and trigger a correction in US Treasury yields.

Treasury yields have already risen 70bps since the end of September 2016 and a December Fed hike is now fully priced. The direction of travel remains upwards, with two or three Fed hikes expected in 2017.

EM spreads, currencies and rates, and US Treasury yields have historically been positively correlated in the initial stages of Fed hiking cycles, so until EM debt valuations have to more attractive levels, we are unlikely to see stabilization of EM risk premiums.

Technicals are under pressure near term

Ut once valuations are restored we expect to see renewed inflows into the asset class.

After around 20 consecutive months of inflows, EM debt and equity inflows experienced sharp reversals in the two weeks following the Trump victory. We do not expect all the 2016 inflows to be reversed but we do expect some investors to monetise the high-single-digit YTD performance in their EM assets.

Nevertheless, on a secular basis, EM debt remains an under-allocated asset class. EM economies represent roughly 50% of global GDP, but account for a much smaller share of global investor portfolios. EM outstanding debt has grown dramatically with most large EM countries now issuing diverse debt securities.

The asset base has grown significantly and now encompasses pension funds, insurance companies and asset managers, as well as a crossover developed-market investor base.

The EM currency depreciation of the past six years requires attention

Local currency debt has borne the brunt of the China slowdown and the ending of the commodity super-cycle in 2010. EM currencies have depreciated by some 40% since 2010, but still present strategic and tactical opportunities going forward.

We are selective in exploiting these opportunities as we realize that EM currencies contribute most of the volatility of local currency debt and can detract from the relatively stable and high carry from local currency rates.

 

Our EM FX investment approach

In order to manage forex risks when investing in local currency debt, we have developed an exhaustive analytical framework, which we call the FX Scorecard. It aims to capture all relevant information for the successful management of an individual currency or portfolio of currencies.

The FX scorecard assesses data and signals from three categories of analysis - fundamental, valuation and technical – and over three time horizons – long, medium, and short, aggregating information over 26 currency drivers. The underlying data is aggregated via historical panel Z-scores, whereby a reading higher than plus one or lower than minus one indicates a strong signal.

Using the FX scorecard to make investment decisions

The FX scorecard allows us to compare fundamental, valuation and technical currency drivers in different time dimensions. When we analyze the results of the FX scorecard we try to answer the following questions:

  • Do the long-term fundamentals support the investment case?
  • Do the medium-term fundamentals reflect the long-term fundamentals? Convergence towards long-term fair value can be slow, but if we have confirmation from medium-term macro dynamics, we are more likely to form a positive view.
  • Are there dislocations between the fundamental and valuation scores? A cheap currency with poor fundamentals is not a viable investment opportunity.
  • Do the technicals support taking a FX position? Technicals are meant to prevent us from catching a falling knife, by picking entry points and formalizing stop-losses and profit targets. Strong momentum against the fundamental or valuation signals means patience is required until the chances of mean-reversion reach a critical level.

Neutral to negative view on EM currencies

We are positive on Central and Eastern European (CEE) currencies.

HUF, PLN, RON (Hungarian Forint, Polish Zloty, Romanian Leu) share these dynamics:

  • Solid long-term fundamentals in terms of indebtedness levels and adequate levels of development as measured by GDP per capita
  • Neutral to positive medium-term fundamentals with low external sector vulnerabilities and limited funding risks, and growth dynamics supported by Eurozone recovery.
  • Neutral valuations and limited risk of reversal of investor positions, as these are not extended

We have a negative bias on select Asian, Central and Eastern European and Middle Eastern (CEEMEA) and Latin American (LatAm) currencies.

In Asia, we are negative IDR (Indonesian rupiah) and THB (Thai baht). IDR has the most extended investor positioning among the EM currency universe we track, having received the most bond inflows this year. The valuation of IDR also screens expensive despite its stable growth and debt dynamics over the long term. Given its exposure to other Asian economies linked to China, we retain a negative bias.

THB screens as expensive on our medium-term and short-term valuation metrics. The neutral market positioning and momentum are offset by our concerns over its exposure to the structural slowdown in China and potential impact of US protectionist policies on low-cost Asian manufacturing exporters. We therefore retain a negative bias.

In CEEMEA, we are negative on TRY and ZAR.

TRY (Turkish lira) has the highest external vulnerability of all EM currencies, as the funding of its current account deficit remains dependent on short-term portfolio flows. While medium-term growth momentum is still present, we expect that elevated domestic and regional political uncertainty (political risk is not covered by the FX scorecard) is going to create serious headwinds to further recovery. Although the domestic Turkish bond market remains the most under-invested among EM peers, we maintain a cautious bias. 

ZAR (South African rand) screens poorly in almost all the categories we assess. It remains a poor country with low GDP per capita and lacks structural reforms to address poverty reduction and productivity growth. Its current account has not declined materially despite the significant depreciation of the exchange rate over the past three years, while growth remains timid. ZAR also appears expensive after the rally YTD while technicals are just neutral.

In Latam we are negative on CLP.

We are negative on CLP (Chilean peso) primarily due to the dramatic increase in both private and public debt over the past three years, although its public debt stock remains one of the lowest in EM. Growth is also lacking and the currency appears expensive. CLP might benefit from a significant increase in infrastructure spending in the US, being one of the major world copper exporters, but we will reassess once we have more information about President Trump’s policies.

We have a neutral bias on a number of EM currencies.

Most of these are commodity-exporter currencies that can benefit from a surge of infrastructure investments in the US and boast very attractive valuations like MXN (Mexican peso) and MYR (Malaysian ringgit), with PHP (Philippines peso) and COP (Colombian peso) not far behind.

Despite their long-term developmental issues – lack of structural reforms to address productivity, poor business climate deterring private investment, high income inequality - we remain neutral on RUB (Russian ruble) and BRL (Brazilian real) because they are the two countries with the strongest external fundamentals: in addition to record high real rates they enjoy high FX reserve coverage and a positive basic balance (current account + FDIs) despite the commodity supercycle coming to an end.  

Perhaps surprisingly given its material depreciation post Trump’s victory, we retain a neutral bias on MXN as it screens as the cheapest EM currency. Investor positions are also at extreme shorts which raises the probability of a sharp reversal. We expect that MXN will continue to trade closely with the political developments in the US and we will look for opportunities to trade the MXN tactically.