In 2017, Emerging Markets (EM) hard currency debt (JPMorgan EMBI Global Diversified) delivered a 10.3% return.
In 2017, Emerging Markets (EM) hard currency debt (JPMorgan EMBI Global Diversified) delivered a 10.3% return. All three components of the return – the carry(1), the risk premium and US treasuries – were positive.
Annual Performance (% in USD) to 31 December 2017
Source: Lipper IM/First State Investments (UK) Limited.
EM Debt Total Return in 2017 by component
Source: Bloomberg and JP Morgan (EMBIG Diversified Index Total Return) as at 31 December 2017
On the economic front, tailwinds for the asset class over the past year were accelerated global and EM growth, higher commodity prices, a weak dollar and an uptrend in global trade volumes. This combination led to falling EM risk premia¹, in particular the risk premia of the riskiest credits (with the exception of Venezuela). After stellar 2017 performance, the question is, what performance can we expect from EM debt in 2018? Will these tailwinds continue? What will be different in 2018?
¹ Risk premia is the return in excess of the risk-free rate of return of an investment
We expect the global environment to remain positive for EM in 2018, with the synchronized global recovery potentially leading to higher EM growth and stable to rising commodity prices. Global trade volumes are rising and EMs are currently benefitting from higher export demand. Despite expectations that G3 Central Banks (including the European Central Bank, the Bank of Japan and the Federal Reserve Bank) will begin exiting quantitative easing (QE) by reducing their balance sheets in 2018, our base case is that global interest rates will not move dramatically higher as G3 Central Banks are likely to adjust their accommodative stance slowly and cautiously. The risk to our positive base case could come from a faster than expected rise in US inflation, which would lead to a more rapid rise in global rates. Given stretched valuations across a number of asset classes, such a re-pricing of global rates could dent the bullish market sentiment and risk appetite.
In this benign global environment, we maintain a constructive view on EM debt. While valuations and spread levels are less attractive than at the start of 2017, we expect another year of positive performance although this cannot be guaranteed. Unlike 2017, however, we expect market returns to be driven by falling EM risk premia and carry amid rising US treasury rates.
The key risks to EM performance in 2018 are likely, in our view, to come from more protectionist US trade policies. If the Trump administration moves to enact such policies it would have adverse effects on a number of EM countries, particularly Mexico.
Technicals and Valuation:
EM bond funds saw record inflows in 2017 on the back of the positive fundamental backdrop for the asset class as well as attractive valuations. As the global backdrop remains agreeable, we would expect inflows to continue into 2018. From a supply point of view, net issuance from EM sovereigns is expected to be lower than in 2017, so we would anticipate a positive supply/demand balance for EM sovereigns. In quasi-sovereign issuers, we see improved financial metrics and a positive rating trend. Companies have been reducing capital expenditure and dividends, postponing M&A, preserving cash and extending debt maturities. There as well, we see a supportive technical position. Whilst new issue supply in 2018 is expected to match 2017’s record at around US$440bn in corporate and quasi-sovereign issuance, net financing needs are forecast at less than $110bn, lower than in 2017.
Gross / Net EM Debt Issuance
Source: JP Morgan, as at December 2017.
As mentioned earlier, EM valuations are less compelling than at the start of 2017, but in relative terms compared to other fixed income asset classes, risk premia in EM in our opinion look attractive, particularly in an environment of rising commodity prices and improving fundamentals.
Political Risk and Policy:
Differentiating factors regarding country performance will be politics, and policy and vulnerability to rising risks associated with changes in US trade policy. Politics will be a key driver for Latin American credits, with presidential elections in Colombia, Mexico and Brazil as well as in Costa Rica and Paraguay. Populism is a particular risk in these countries, as opinion polls show that popular trust in traditional political parties is at historically very low levels. This is especially true for Brazil where the Lava Jato corruption scandal has led to high voter discontent.
Trust in Political Parties
Source: Latinobarómetro 2017
The current Mexican administration has also been tainted with corruption as is reflected in Mexico’s rank in Transparency International’s corruption perception index that has fallen dramatically from 106 to 123 between 2013 and 2016. We expect the market to start pricing in more political uncertainty in Mexico and Brazil over the next few months. If however market-friendly candidates win the presidency both credits could tighten as reforms would likely be back on the agenda.
Political risk will also remain a key concern in the Middle East in our view. Despite a current strong oil market a number of Middle Eastern countries continue to run sizable fiscal deficits and a meaningful stabilisation of fiscal accounts is unlikely given the high inelasticity of expenditures. We expect that issuance, particularly from GCC (Golf Cooperation Council) countries, will remain heavy as the Eurobond market is used as a primary source of deficit financing. In order to place this supply, we would expect some issuers to offer a premium to the current market spreads.
2018 Middle East Fiscal Breakeven Oil Price Estimates
Source: Bloomberg, as at 17 January 2018.
In terms of policy, progress on structural reforms will be key for longer-term performance. In Latin American, improved fiscal performance is critical, particularly in Argentina, Costa Rica, Colombia, Ecuador and El Salvador. We would expect risk premia to fall in those countries where policy is tightened in a sustainable fashion. In other countries such as Turkey, monetary policy is the most important risk factor, while in some Asian countries effective implementation of infrastructure investments is a major concern of markets.
Current Themes in our Portfolio:
In view of our bullish view on global growth, we are constructive on commodity prices and generally prefer commodity exporting countries over commodity importers such as Central Europe or China. In terms of regions, this translates into a large underweight positions in Asia and Central Europe where we see stretched valuations and little upside potential.
DOE Crude Oil Total Inventory
Brent Crude Oil
Source: Bloomberg, as at 17 January 2018.
*DoE: Department of Energy
In the low volatility environment of 2017, there has been little credit differentiation. Given the heavy election calendar for EM countries with a wide range of potential outcomes, we expect this to change in 2018. Particularly in Latin America, we see little risk associated with the North American Free Trade Agreement or the election priced into Mexican risk premia for example and as such are lightly positioned there. Among the large economies in Latin America – Brazil, Mexico, Colombia and Argentina – we see most value in Argentina, where we see a structural reform agenda being implemented and where there is no electoral uncertainty. The Fund therefore holds a sizeable overweight position in Argentina.
Similarly, among the less liquid countries with low credit quality and rating, we have seen little dispersion and see opportunities to generate performance by holding positions in countries with credit improvements which are not yet priced in. Among these credits, we are structurally overweight Egypt and Ukraine, both countries where we expect the relationship with the International Monetary Fund to anchor the reform projector. On the other hand we are cautious on Lebanon which is not insulated from the tensions between Iran and Saudi Arabia and where we do not see enough political risk priced in.
In quasi-sovereigns, we are most constructive on metals, mining and energy companies outside the Middle East. Given the sizeable expected issuance, we look to buy what we believe are attractively priced new issues and take advantage of bouts of volatility.
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