Introduction

It’s no secret that emerging markets debt (‘EMD’) has gained significant traction in recent years. As the hunt for yield has intensified across global asset classes, investor interest in EMD is high, consensus is long, positions are large – and in our view, valuations are starting to look stretched. Could this market be reaching an inflection point? Indeed, history tells us that crowded positioning and high valuations can be followed by sharp corrections. For investors in EMD, a key question at this point in the cycle is whether this time could be different. The macro backdrop for emerging markets seems to have improved significantly over the last decade, where countries across the complex have taken measures to improve their stability.

To understand whether EMD performance in hard and local currency is likely to be sustained over the coming months, it’s important to think about the reasons for current market bullishness, and the potential for tailwinds to fade. Ultimately, we believe that history may repeat itself, despite improved fundamentals in some major EM economies. We argue that a short beta position could be worth investigating – but that there could still be opportunities, even in the context of a potential sell-off.

Market confidence remains high, despite a dip in EMD quality

Unlike developed market debt indices, EMD indices are comprised of both investment grade and high yield instruments – and the changing proportion of these through time reflects the quality across the asset class. For example, Figure 1 shows the percentage of investment grade bonds in the EMD hard currency index, charting its increase from nearly nothing in the early 1990s. As the broad EM growth story played out over the following decades, with China driving demand and supporting commodity exporters, the quality of EMD increased, peaking at around 75% in 2013. Since then, it has been decreasing against a backdrop of multiple downgrades.

Figure 1. EMBIG investment grade market weight

Source: Bloomberg and JP Morgan, as of August 15, 2017. The content of this chart should not be construed as a recommendation for purchase or sale.

But this dip in quality has not deterred investors. Figure 2 shows how EMD has continued to perform positively over the period, where the majority of key market shocks in the last ten years have been either global or concentrated in developed markets – a contrast to the succession of EM-related crises in the preceding years.

Figure 2. EMBIG Total Return Index since inception

Source: Bloomberg and JP Morgan, as of August 15, 2017. The content of this chart should not be construed as a recommendation for purchase or sale.

EM countries have taken steps towards stability

How can EMD be experiencing both a decline in quality and positive performance at the same time? The broad answer here is that the major EM economies have started to adopt more orthodox policy, and their fundamentals have improved as a result. Not all, but many of the largest EM countries have taken a number of measures to increase stability, including inflation targeting, moving to floating rate currencies, and improving their balance sheets. Figure 3 shows the difference in inflation and FX reserves today for a range of EM countries, compared to December 1995. For example, Brazil was running inflation of nearly 22.5% in 1995, which has fallen to less than 3% today – and the same can be said of many other EM economies. At the same time, FX reserves have increased substantially. Of course, one of the most important dynamics here is currency, where low reserves were particularly dangerous in the 1990s given that many EM countries pegged their currencies to the US dollar (and thus less able to absorb external shocks if they arose). Since then, many EM countries have moved to floating exchange rates – meaning that although they have larger FX reserves available, they are also less likely to need them.

Figure 3. Comparing inflation and FX reserves – today versus 1995
  Current inflation Dec 1995 inflation Current FX
reserves (USD bn)
Dec 1995 FX
reserves (USD bn)
 Brazil  2.7%  22.4%  USD 374  USD 50
 Chile  1.7%  8.2%  USD 39  USD 14
 Mexico  6.4%  52.0%  USD 171  USD 17
 Peru  2.9%  10.2%  USD 62  USD 8
 China  1.4%  10.1%  USD 3,076  USD 102
 Philippines  2.8%  8.2%  USD 74  USD 6
 South Korea  2.2%  4.8%  USD 270  USD 22
 Hungary  2.1%  28.3%  USD 27  USD 12
 Poland  -0.7%  19.8%  USD 108  USD 15
 Russia  3.9%  131.5%  USD 418  USD 17
 Turkey  9.8%  78.9%  USD 90  USD 12

Source: Bloomberg and JP Morgan, as of August 15, 2017. The content of this chart should not be construed as a recommendation for purchase or sale.

Another benefit of floating-rate currencies is that they give the market the opportunity to signal its feelings towards policymakers. Brazil is a good example here, where Figure 4 shows how USDBRL increased from around 2.2 to nearly 4 during the first election of President Luiz Inácio Lula da Silva, as markets feared the leftist policy agenda of this populist former labour union leader. At the same time, the country’s debt became more costly to service – reflected in the blue line, which shows that the Brazilian US dollar 3-month onshore rate increased dramatically. This picture posed significant political risk, and Lula was forced to adopt more orthodox policies – for example, among his first appointments was the pro-business Henrique Meirelles, former head of BankBoston, as President of the Central Bank of Brazil. Such measures softened the market’s sentiment towards Lula’s administration over time. In this way, floating currencies may help enforce a level of discipline in EM countries – where previously dollar-pegged currencies have allowed administrations to pass the buck.

Figure 4. Brazilian FX and rate markets around first Lula election

Source: Bloomberg, as of August 17, 2017.

Floating currencies have also helped EM countries withstand recent shocks. For example, the 2013 US ‘taper tantrum’ exposed significant current account deficits across EM countries. After the tapering scare, we started seeing an improvement in current accounts – and today they are at neutral levels on average. Floating rate currencies played an important role here: currencies depreciated, imports fell, and eventually these countries exported more as they became more competitive – improving both trade and current account balances.

Is EMD reaching an inflection point? Despite some improving fundamentals, there are reasons for caution

Given the improvements in the stability of many emerging market countries in recent years, it’s easy to see why EMD continues to attract interest from investors. However, understanding the drivers of previously positive market performance is not the same as believing that they will continue – and we believe that current bullish sentiment may be overdone for a range of reasons.

Investors are too focused on EM FX versus the dollar: the euro matters just as much

When it comes to currency valuations, investors may be focusing too closely on EM versus the US dollar, and failing to understand the significance of the euro. We believe that the euro is as important a comparator – not just because the eurozone represents a major trading partner to many EM countries, but also because historically the euro itself is highly correlated to this universe. While we believe that EM currencies are looking attractively valued versus the dollar on an inflation-adjusted basis (a real effective exchange rate or ‘REER’), they seem expensive against the euro.

Inflation may be around the corner: Federal Reserve (Fed) may need to act more quickly than the market is pricing in

Since the financial crisis, unemployment in the US has continued to fall. While this has reflected good news for America’s recovery, a tight labour market exerts inflationary pressure. The mysterious absence of US inflation in recent months may have dulled some investors to its dangers, but we believe that once prices start to rise properly, the Fed may need to act more quickly than the market is pricing in. Indeed, while some investors may argue that positioning for inflation is simply a waiting game – that there is no point in worrying until the signals themselves appear – this approach would (by definition) put the Fed well behind the curve, forcing it to act quickly. Aggressive hiking by the Fed has been one of the drivers of recessions in the past.

Financial conditions are accommodative: European Central Bank (ECB) is to Fed today what shadow banks were pre-crisis

A broader question is whether the Fed can really still control financial conditions. Figure 5 charts US financial conditions (the blue line), as measured by the Chicago Fed. Readings above zero (RHS) indicate tight financial conditions, and below zero – as we’re seeing now – mean accommodative conditions. The grey line shows the Effective Fed Funds Rate (LHS), which is historically correlated with financial conditions, and this is an intuitive relationship. When the Fed hikes rates, conditions tighten and vice versa. However, this correlation breaks down in two periods: in the years leading up to the 2008 crisis, and now. In both periods, financial conditions remained accommodative, despite Fed hikes. How can this be? The answer is that the Fed is not the only player in the system. When it hiked rates in 2004, financial conditions remained loose because the shadow banking system provided easy mortgage availability. Today, a similar dynamic is playing out, but this time itis other central banks, not the shadow banking system, which are contributing to an accommodative backdrop as the Fed raises rates.

Figure 5. Can the Fed still control financial conditions?

Source: Bloomberg, as of July 31, 2017.

Global central bank balance sheets have grown significantly (see Figure 6), led by the ECB. In Europe, it’s easy to understand why the ECB injected liquidity earlier this year – as Brexit negotiations began, and in advance of the French election (with the risk of a populist anti-European president). However, now that the political picture in Europe is somewhat more stable, combined with improving economies and an uptick in inflation, there may be fewer reasons for the ECB to hold on to its large balance sheet. If it does start unwinding, broad fixed income markets (including EMD) could be negatively impacted. This move could prove positive for the euro, but we believe that sentiment on this currency is getting ahead of itself, and there are broader reasons why we feel its strength versus the dollar is unlikely to be sustained.

Figure 6. Central bank balance sheets have expanded dramatically

Source: Bloomberg, as of August 14, 2017.

Inflation in Eastern Europe is starting to look unhinged

We’ve highlighted that we believe inflation is on the horizon in the US, but investors in EMD will also be watching regional dynamics – and it is clear that Eastern Europe is starting to see rising prices. For example, unemployment has reached multi-year lows across Poland, Hungary, Romania and the Czech Republic, and wage pressure is being felt in these countries. Of course, it’s worth remembering that the low inflation we have seen in recent years has been an exception for these countries, who are used to seeing much higher levels. So this could be a return to historical norms – but the direction of travel still matters.

The recent scramble for EM currency rings alarm bells

At the beginning of 2017, market consensus was short on EM currency. However, over recent months, positioning has moved in the opposite direction, to almost all-time long. This has only happened in a couple of instances before now – in 2007, summer 2011 and early 2013 – and each time was followed by sell-offs.

 

EMD supply snapshot: everyone’s joining the party

This September, the small central Asian country of Tajikistan entered the bond market. This is a country with 8.3 million people, and a GDP of around USD7bn1. Tajikistan raised USD500m from its first ever 10-year international bond, which offered a yield of 8% at the point of issue – and high demand soon drove it down to 7.125%2.

We think this is a good example of the indiscriminate frenzy which has enveloped EMD markets. Even a cursory analysis reveals that a large share of Tajikistan’s GDP comes from the remittances of oil workers overseas (most of whom are in Russia) – so the risks are clear. Indeed, it would be understandable to question how many of Tajikistan’s new creditors had any previous knowledge of the country before investing.

1. Source: International Monetary Fund, estimates for 2017. Further information is available here
2. Reported in the Financial Times, September 7, 2017. Link to article here

 

What about EMD in hard currency? Avoiding the race up the risk spectrum

In light of the risks at play in EM currencies, some investors may look towards hard currency instruments. This part of the EMD market has seen significant flows and valuations have become stretched in our view – but it continues to attract investor interest. We believe that markets may be missing a relatively obvious point about the supply picture. 2016 was a record year for issuance of new bonds, and 2017 is looking set to beat it. As of the end of July, issuance is up by 19%1. Importantly, this is driven by a sizeable increase in high yield issuance, so quality of these assets has declined, and a higher proportion of issuance has come from frontier markets. This is intuitive, as investors flooding into this asset class have taken the low-hanging fruit, and are now being pushed further out on the risk spectrum. In this context, we believe it is more important than ever to think carefully about individual exposures, where each instrument is likely to provide a very different set of risk, return and yield characteristics.

Even if EMD is reaching its top, there may still be opportunities for investors

In our view, there is no shortage of reasons to be cautious on the outlook for EMD. However, this does not mean that there may not be opportunities for investors over the coming months. Indeed, just as markets have rushed to buy EMD seemingly indiscriminately, it is also possible that they will sell indiscriminately in the event of a correction. In this scenario, given the inherent liquidity constraints of this asset class, we believe that EMD managers are only likely to be able to raise capital quickly through the liquidation of healthier sovereign credits and local currency denominated positions. This could offer potentially attractive opportunities for EMD investors to add exposure through healthier assets. In this context, we believe that rigorous risk-adjusted total return approach is more important than ever.

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