Emerging Market debt outlook
The EM debt space has become a perilous place over the last 12 months, as testified to by record outflows. We argue that many investors are falling victim to a herd mentality which is causing them to neglect obvious opportunity. We believe under loved countries such as Russia and Venezuela offer compelling value for those willing to break away from the crowd.
A short version of the article has been published in the Financial Times on 28th March 2016.
1. EXECUTIVE SUMMARY
In light of today’s stunted local currency debt valuations, the improvements in the current accounts in the larger Emerging Market (EM) countries, and modest positioning by investors in local currency debt, we are fairly positive on some important segments in the space. In the local currency space we would envisage focusing on countries such as Brazil, Russia, Turkey, Chile, and South Africa. In hard currency, where we are more defensive, we favour the 2-5 year band of the sovereign curves of nations with floating currency regimes, and strong foreign reserves positions. In this latter situation, we believe that the pull to par may offer protection against volatility on EM spreads and USD rates.
This article discusses the scope of the challenges faced by China whilst also examining the extent to which other EM economies are imperiled. Through this investigation, we hope to evidence these aforementioned opportunities in the EM local and hard currency debt markets.
2. WHAT’S GOING ON IN CHINA?
Everyone knows that China is “big”. But few realise that, as a source of global aggregated demand, it is actually much bigger than its GDP figures portray. Measured by GDP, China accounts for 57% of the US number, but as a consumer of imports, for example, the two stand on a relatively even keel. As chart 1 shows, total global imports more than tripled between 1999 and 2012 from $5.8 to $18.2 trillion (9.2% annualized growth). Over the same period Chinese imports increased eleven times, boosting the nation from playing a supporting role to being an importer with the same stature as the US or the Eurozone.
From 2012 onwards, however, China’s pace of import growth markedly declined. This appears to have been due to the rebalancing experienced as the economy transitioned from being export-led to domestic demand driven. This new “growth” has been slower and less commodity intensive, seemingly precipitating a sharp fall in commodity prices worldwide. The level of noise around these developments has led many commentators to wonder whether China’s economy is on the verge of buckling, potentially causing a global crisis.
Chart 1: International Imports (cif in Mill USD)
Source: Haver analytics and Man GLG calculations. Please note that 2015 data has not yet been published.
We think such an outcome is unlikely, although we do accept that the state of play is challenging to analyse correctly. There are many schools of thought on what the ‘real’ situation in China is. The proliferation of data sources and specialists allows for a wide range of speculation that can cause more confusion than clarity. We believe that an effective, but often overlooked, approach is to focus primarily on liquidity. The M2 measure of money supply includes all cash and checking accounts, as well as savings deposits, money market mutual funds and other time deposits. We believe that credit will fall across these categories (since money borrowed becomes money deposited) and thus the movement in M2 will broadly reflect the path of credit, in our view.
Chart 2 shows how the ratio of M2/GDP has evolved for various countries. At first sight, the situation for China seems highly concerning. Money supply, which was already at high levels in the early 2000’s, has grown at a furious pace since 2008. This has been chiefly due to stimulus injections by the government attempting to help the economy recover from the Global Financial Crisis (GFC). Nevertheless, the data does seem to point to rapidly burgeoning excess liquidity which could hint at the credit overhang problem, that many are fretting over.
Chart 2: Evolution of M2/GDP ratio for selected countries
Source: Bloomberg. Note that Japan data is not available before Q2 2003.
Investigating more closely, however, we are convinced that the situation is more nuanced. Looking at chart 2 in conjunction with chart 3, it is apparent that, in all countries except China, M2/GDP seems to have an inverse relationship to inflation (i.e. the lower inflation, the higher the propensity of the population to hold cash balances). In China, we see M2/GDP increasing with far greater consistency. We believe that a possible reason why the Chinese have such a strong inclination to hold cash is because of the bottleneck they face in converting it to foreign currency, a process significantly hampered by capital controls. In light of this, we do not think it is appropriate to think of liquidity and credit in China in the same way in which we would for a country with relatively free and deliverable currency markets.
Instead, we have confidence that the government will be able to negotiate a softer landing in this area. M2 has risen so markedly since mid-2014 because the PBoC has had to make significant liquidity injections to counter the negative sentiment that was weighing on the CNY. If the government maintains the integrity of the nation’s capital controls on outflows we think that the CNY should be able to continue to depreciate gradually, without generating significant additional stress, and over time allow for a gentle reversion of the M2/GDP ratio to the 1.7 level sustained in the aftermath of the GFC.
Chart 3: Y/Y CPI of selected developed and emerging economies
The next concern around the level of credit in the Chinese economy relates to its size compared to foreign currency reserves. Currently, M2 is around six times larger than reserves at the present exchange rate level. In a hypothetical extreme scenario where all currency in circulation and short-term deposits were exchanged into foreign currency, and the PBoC used its reserves to facilitate the exchange, USDCNY would need to multiply by at least a factor of 6, from 6.55 to 39.3 CNY per USD. The bearish view would argue that even a small run on the system might threaten the reserve pile to such an extent that a sharp devaluation of the currency would be necessitated.
However, the data in chart 4 tends to counter this view. It shows that, although the 6x M2/Reserves level may give initial sticker-price shock, it is actually comparatively low relative to the numbers seen in the late 1990s. This suggests that we could be still some way from what would constitute uncharted and unsustainable territory.
Chart 4: Evolution of China M2/Reserves
Source: Haver Analytics and Man GLG calculations.
We do accept that policymakers are facing some tough challenges. These may well be made more difficult to tackle due to the possibility that China’s productivity is structurally slowing. However, we believe that the situation is far from alien and far from irretrievable.
The contagion effect is such that we currently see currency markets across EM pricing a new and dramatic contractionary phase in the economic cycle. We are skeptical that such a situation will transpire.
3. CHINA’S IMPACT ON EM CURRENCY MARKETS
As already alluded to, there is a general perception that China’s woes are endemic to EM. Our view is that the link is not as explicit as has perhaps been portrayed. Intriguingly, and as demonstrated in chart 5, commodity prices started falling in early 2011, well before China began to reduce demand for imports. We believe it likely that – in a world where everyone appeared to be planning for continued China-led economic expansion – just a hint of deceleration was enough to have many fearful producers drowning in oversupply. A seemingly interconnected trend is apparent in EM currencies. As can be seen from charts 5 and 6, commodity peaks in 2007 and 2011 coincide fairly neatly with highs in EM currencies.
Chart 5: China and US imports and CRB commodity index
Source: Haver analytics.
Since its peak in 2011, the CRB commodity index has fallen by 34%, as at September 2015, while the currency component of the EM local bond index fell by 43%. Given these declines it seems we are beginning to see the first hint of supply-side contractions. In any event, and as previously described, we do not believe that China’s process of deceleration is likely to continue much further. It is perhaps typical of human nature to assume the next five years will be like the last five years. In our opinion, many investors have fallen into this trap, and seem to have little doubt that EM currencies will continue to lose what value they have left.
Chart 6: Evolution of FX component of JPM GBI-EM GD (rebased to 1)
Source: JP Morgan, Bloomberg, and Man GLG calculations.
4. THE STATE OF PLAY WITH COMMODITIES
So to recap: we have discussed why we feel it would be feasible to see Chinese policymakers bring liquidity conditions to the more sustainable levels seen in the recent past. The implication of this is that the government will remain in control of their economy. Reinforcing this point is the fact that, according to the data we follow, Chinese growth seems to be stabilizing, albeit more gradually than we have been used to. We have also asserted that this is playing out to the backdrop of an international context where, with the exception of oil, supply for many commodities appears to be starting to contract as a reaction to the weak price environment.
Our current positive view is not just based on fundamentals but also, turning to look at market positioning, we think that many investors may view the fall in commodity prices and emerging market currencies as indefinite. We would argue that this view is too simplistic.
Our reasons for this statement are illustrated in charts 6 to 10 which show the evolution of prices for the main commodities produced by large emerging markets, adjusted to account for inflation. It may be observed that, in most cases, prices are currently residing at the lower end of the ranges seen over the last thirty years. We think that the market is exaggerating the weakness of the outlook for commodities, and by implication for EM currencies, even though we acknowledge that we are still likely to see significant volatility.
Chart 7: Soybean prices (as a proxy for agricultural EM exports) adjusted by US CPI
Source: Bloomberg and Man GLG calculations.
Chart 8: Evolution of CRB commodity index adjusted by US CPI
Source: Bloomberg and Man GLG calculations.
Chart 9: Evolution of oil prices adjusted by US CPI
Source: Bloomberg and GLG calculations.
5. THE STATE OF PLAY WITH EM CURRENCIES
In chart 10, we compare the evolution of the net long/short currency position among CME speculative currency investors (i.e. the absolute number of long contracts written minus the absolute number of short agreements) against a basket of five currencies which follow a similar pattern of returns as the FX component of the EM local bond index1. The two series exhibit a consistently positive correlation, suggesting that very large net short positions have been accumulated. Indeed, Chart 10 points to an environment where investors are positioned at historically short levels.
Chart 10: USD speculative position at CME vs. currency component of EM local currency index
Source: Bloomberg and GLG calculations.
We do not believe this position can be maintained. Chart 11 shows that the short positioning in EM FX by market participants is extreme by historical standards. When one takes into account how expensive it is to maintain these trades (e.g. 6.9% p.a. in the case of going short the EM local bond index), it is difficult to see how they can continue for much longer. This appears to be yet another indicator in support of our view that the future duration of EM currency underperformance may be limited.
Chart 11: Speculative currency positioning - # of STD away from historical average
Source: Bloomberg and GLG calculations.
From the fundamental angle also, we feel these currencies are also more likely to enjoy a macroeconomic tailwind. It seems to us that many flexible currency regimes (i.e. those that allow their FX rate to be set by international markets) have, through currency depreciation, finally begun to generate improvements in the current accounts, and by extension in the balance of payments. This could well be supportive of slower currency depreciation, or outright appreciation, going forward.
To illustrate this point consider charts 12-15. These show the progression of the terms of trade (ratio of export to import prices, compiled in this instance by Citibank), real exchange rates (as estimated by JP Morgan), and the current account or trade balances of Brazil, Russia, Chile and Turkey. These are all countries whose currencies have depreciated noticeably in response to the changes in the external environment since 2011. It is clear that there have been significant improvements in the current accounts or trade balances. If one accepts our previous contention that many investors are either underinvested or short, then it would appear to be difficult for these economies to continue to experience capital outflows capable of depreciating their currencies much more severely. Indeed, we believe the current account behavior is potentially supportive of appreciation in the near term.
Chart 12: Brazil – 12-month moving average Current Account Bal., Real Exchange Rate, and Terms of Trade
Looking specifically at Brazil, as per chart 12, we observe that although a lot has been said about the poor performance of BRL over the last few years, the current account has improved noticeably over the last year (by $43bn on an annualized basis). This has happened despite a fall in the terms of trade which reached a nadir only comparable to the lows of the early 2000’s (which itself forced a devaluation of the currency to a similar level to that which we see today). These two factors have combined to cause a significant improvement in the supply/demand of foreign currency in the domestic economy. We find it unlikely that such a pattern will repeat itself and that makes us more confident that the BRL has found something of a resistance level, as it did in the early 2000’s. In further support of this argument, we believe that we are unlikely to see a repeat of the dividend remittances and capital outflows that happened between late 2013 and mid-2015, as it would appear that most money that could leave has already done so.
Russia’s case is even more striking. The terms of trade today are close to what they were before the 1998 devaluation, and lower than what they were at the weakest level during the 2008/2009 Global Financial Crisis. Bizarrely, however, the current account surplus is where it was on average between September of 2007 and September of 2012. During this period Brent oil, Russia’s chief export, averaged $92 per barrel2. We believe that this dislocation may very well act as a ballast to the RUB.
Chart 13: Russia – Current Account Bal. vs GDP, Real Exchange Rate, and Terms of Trade
Another currency that we believe looks noteworthy is the Chilean peso, where the real exchange rate is near lows seen only during the GFC, or in the early 2000s (when Chile was under a massive terms of trade shock). Despite this, the current account has been improving in the last two years whilst terms of trade are at fairly attractive levels, this is illustrated in chart 14.
Chart 14: Chile – Current Account Bal. vs GDP, Real Exchange Rate, and Terms of Trade
Finally, Turkey is a country that has traditionally run a structural current account deficit mostly explained by its energy shortfall. As can be observed in chart 15, however, the improvement in the terms of trade over the past few years has made possible a significant improvement in the current account. The TRY has started to tick upwards in response and we feel this may be the start of a sustained recovery.
Chart 15: Turkey – Current Account Bal., Real Exchange Rate, and Terms of Trade
These 4 examples account for roughly a third of the ELMI (JP Morgan Emerging Local Markets Index) components. Other than Chile, all of them offered yields north of 10% p.a., as of 29th February. We feel there are a number of other examples which follow this pattern of a substantially undervalued currency combined with supportive external accounts that we believe give a greater chance of near-term upside. We hope, however, that the four examples we have shown demonstrate how extreme the currency selloff has been. We hope also that we have offered some perspective on how the present adjustment process in external accounts resembles what has happened in previous periods, when valuations slumped.
To reiterate, we believe that the local currency segment of the asset class, which has had very poor performance since 2011, is now at a point where the risk/reward profile could be seen to be extremely attractive. Even if currencies like the BRL, RUB, TRY and CLP continue to depreciate gradually, we believe the carry differential and undervaluation cushion on offer are so significant that the segment is difficult to ignore.
6. EM HARD CURRENCY DEBT
We expect the future for EM hard currency debt to be more complex. Whilst we think that the next three years will be positive for most of the EMBI Global benchmark (which is hard currency denominated), we believe that the segment will be challenged on three different fronts in the near term:
- Potential credit events in countries where the balance of payments has not adjusted
- Potential increase in US rates
- Positioning indigestion
Table 1 shows those countries where we see relatively lower probabilities of default on external sovereign debt over the next three to five years. Other than Kazakhstan and China, all have had flexible exchange rate regimes for a number of years. This has allowed them to adjust their current account balances and deal with outflows in the capital account, avoiding the types of crises that were typical of the 1980’s and early 1990s. As the table shows, all of them also have relatively high levels of foreign currency reserves that could help them service their debt.
Table 1: Countries with flexible currency regimes and strong foreign reserve positions
|z spread||Spread dur||% MV EMBIG||Public external debt $bn||Foreign reserves $bn|
Source: Haver Analytics and Man GLG calculations.
These countries in the table above account for roughly 68% of the EMBI Global index. The potential issue to consider is that almost 60% of the remainder is composed of smaller countries that have either fixed or heavily managed FX regimes. At the same time, a large proportion of this residual 60% are commodity or energy exporters. We feel that the currencies of these smaller countries have therefore not depreciated as much as required to ensure that the balance of payments adjusts to the more difficult external conditions, in the way we have seen in the larger, more flexible economies. There is a risk in our opinion that credit dislocations in this group of smaller countries create enough noise to act as a contagion for the rest of the benchmark.
The second challenge is that we are currently in an environment where there is a greater possibility of US rates normalizing. Given the very long duration of the index (circa 7 years), even gradual rate increases could have an outsized negative impact on the EMBI Global returns.
Finally, as we can see from table 2, investor positions in hard currency debt look heavy, and there is a meaningful risk of disorderly liquidations. Table 2 lists a number of major EM external debt funds, showing their betas relative to the two main EMBI benchmarks. This implies that the majority of managers are running significant levels of risk. We do not believe that these levels were increased as a proactive reaction by managers to spread widening. We are confident of this as betas were even higher between 10/29/15 and 12/31/15 when spreads were on average 60 bps tighter than they were on the 29th February. Instead, we think this is a consequence of outflows which were fulfilled unevenly across the risk spectrum of the particular portfolio. In our opinion there is a strong likelihood that if credit events were to take place across the aforementioned group of smaller countries within the EMBI index, or if additional investment grade countries got downgraded to high yield, then managers would be forced to liquidate some of their excess risk, triggering a spiral of additional widening.
Table 2: Betas of selected EM hard currency funds vs. EMBI Global indexes
|JPM EMBI Global Diversified||JPM Emerging Markets Bond|
Source: Bloomberg. These are the 19 largest EM hard currency funds as at 31 December 2015.
In this report we have sought to evidence our belief in the following points (numbers refer to the sections in which they were covered):
|(2)||We believe that Chinese policymakers have the tools available to them to effectively deal with the current challenges of excess liquidity and the credit overhang that is associated with it|
|(3 and 4)||Because of (2) it is possible that the commodity and EM currency pain, that has been related to China’s struggles, is reaching an inflection point|
|(5)||Certain EM currency valuations and yields could be seen to be at very attractive levels when one considers the supportive behavior of the balance of payments|
|(6)||The situation with EM hard currency debt is more complicated, particularly given the heavier concentration of bond fund investors.|
In terms of local currency exposures, we favour countries with flexible FX regimes, attractive local yields and recovering current accounts. In terms of external debt, we are most attracted to the 2-5yr bracket of the countries with floating currency regimes and strong foreign reserves positions. In this latter situation, we believe that the credit profile and pull to par should offer protection against volatility on EM spreads or USD rates.
1. The currencies in question are: MXN, CAD, EUR, GBP and AUD. These are selected as their futures contracts are traded daily in significant volumes on the CME. Together these have historically exhibited a high positive correlation with the FX component of the EM local bond index.
2. Source: Bloomberg. Please note that throughout this letter, where a statistic is not attached to a graph its source will be Bloomberg unless otherwise stated.
All numbers come from Bloomberg unless otherwise stated. Past performance is not indicative of future results. Returns may increase or decrease as a result of currency fluctuations.
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