Why Has EM Underperformed – Is This Time Different? – June 2018

 

Recent weakness in EM belies underlying fundamental strength in a maturing asset class.

Emerging market (EM) fixed income has come under pressure this year, underperforming its developed market (DM) counterparts. In our view, the reasons for this underperformance are varied and range from trade war concerns to rising US rates and a strong US dollar. We will examine each concern in turn below.

Many investors fear a repeat of the EM crises of the 1990s in which weakness in one country (Mexico) spread to others (Thailand), leading to massive corrections across global markets.  We believe many of the issues of crises past have been remedied to a large degree thanks to countries allowing their currencies to free float and EM corporates increasingly funding themselves in their home markets in local terms. Strong corporate fundamentals and attractive valuations suggest EM may present an attractive buying opportunity.

Rising Trade War Tensions and EM Currency Devaluations

In the last few months, the Trump administration announced a series of global tariffs on steel and aluminium as well as a goods tariff on China, estimated at $50bn.1 Tariffs were levied not just on China, but also on long-standing US allies like Canada and the EU.

Markets have nervously absorbed the news fearing that, as tariffs are countered, tensions escalate leading to trade wars. Trade wars could ultimately lead to a poorer quality of growth/inflation dynamics and, in the case of 2018, the tariffs could stall the synchronised uptick in global growth.

In an effort to counter trade tariffs, we believe that much of the emerging markets has devalued their currencies. Short-term currency movements are most commonly seen as a sentiment gauge, a method whereby the market shows its degree of confidence in the independence and effectiveness of central banks and the fortitude for governments to stick to reform plans and spending disciplines.

This sentiment gauge or proxy “market voting machine” can be very effective in removing or bringing governments back in-line as we have seen in recent history in India, Brazil and South Africa.

While robust FX reserves and plentiful room to use macro tools have helped manage the controlled adjustment, nothing is free.

Excessive currency movements are destabilizing and force central banks to tighten monetary policy aggressively, which may lead to a weakening of consumer consumption, a slowing of the investment cycle, an increase in inflation and ultimately a weaker macroeconomic environment.

For companies, foreign exchange fluctuations are more noise than danger as defaults are rarely driven by currency mismatches. Rather, defaults are more a function of the falling prices of goods and/or the mismanagement of balance sheets.

Export-driven sectors benefit from the increased US dollar revenue stream relative to local currency driven costs, thereby countering the costs of tariffs.

Normalization of US Interest Rate Policy

Since US Federal Reserve (Fed) Chairman Ben Bernanke’s mention of the word “taper” in 2013, the Fed has been on a path to interest rate policy normalization.

That is, the Fed is increasing short-term interest rates to bring them more in-line with historical norms and also shrinking its $4 trillion + balance sheet by allowing current investments to roll-off without reinvesting the proceeds.

Removing liquidity from the system is generally seen as a negative for all asset classes, including EM, as funding channels become more expensive.

Certainly in 2013, when the Fed first announced the change in policy, the EM asset class suffered as EM balance sheets were in poor shape after feasting on cheap liquidity for five years.

This experience hasn’t been taken lightly, and since 2013 we have observed EM corporates and sovereigns have been busy strengthening their balance sheets, raising FX reserves, reducing current account deficits (in aggregate are now positive), restricting credit growth and now revaluing currencies.

At present, we believe EM is less dependent on international financing and more resilient to tightening monetary policy.

Rising US Rates Mean Higher US Dollar Funding Costs

For EM companies that fund themselves in US dollars, rising rates means that their US dollar funding costs have increased. This is less of a problem today than it has been in years past as EM companies are no longer dependent on international capital markets. Many corporates have also hedged their US dollar debt exposure.

Local markets have increased in both size and breadth. For EM corporates, we believe it has now become a question of what is the most cost effective market to raise funds.

As the cost of funding has risen in the US dollar market (due to higher rates), fewer first-time EM companies have tapped the US dollar market (Fig.1). We have noticed a strong preference for first- time EM corporates to fund themselves locally given more favourable terms.

Fig.1 highlights last-twelve-month (LTM) first-time issuers accessing the US dollar market as a percentage of all EM issuers.

Strengthening US Dollar – Less of an Issue for Countries that Allow their Currencies to Float

Rising rates generally coincide (although not always these last few years) with a strengthening US dollar. In the past, many EM currencies were pegged to the dollar. Movements in the value of the dollar had a significant impact on the local currency given the peg.

Many countries have since moved away from pegs and now allow their currencies to freely float. A floating currency means movements in the dollar have less of an impact and grants local central banks significant power to use tools to revalue their currency.

Idiosyncratic Events – Election Calendars

Another source of instability is the EM election calendar. Turkey (Erdogan won as of the time of writing this piece), Mexico and Brazil each face presidential elections within the next 4 months.

The uncertainty surrounding the political climate in these major EM economies is a source of volatility and potential pricing pressure.

EM Fundamentals Strong and Valuations More Compelling

We believe EM fundamentals are strong. Both EM sovereigns and corporates have done much to right their balance sheets since the financial crisis (please see Fig. 2). We generally see lower levels of leverage compared to developed markets and companies are generally well capitalized.

In general, corporate balance sheets look like they are in the early stages of the economic cycle. Solid economic growth provides a strong tailwind for these companies (please see Fig. 3).

EM spreads have widened significantly since mid-April, when tariffs and trade wars first became a topic. At present, the ICE BofA ML High Yield Emerging Markets Corporate Plus Index (EMHB) is 100bps wider than the broad US high yield market (Fig. 4).

This of course begs the questions, does EM offer value to the yield-seeking investor?

We believe corporate fundamentals are certainly strong and companies are not hostage to US dollar funding. The concern is of course the unpredictable nature of macro events, particularly the threat of an escalating trade war.

As is always the case, while there is currently greater risk, we believe the rewards are also greater. As of 26 June, the ICE BofA ML High Yield EM Corporate Plus Index (EMHB) has a yield-to-worst of 7.23% and an average credit quality of BB3.

The ICE BofA ML US High Yield Index(H0A0) is offering a yield-to-worst of 6.27% with an average credit quality of B1.

Simply looking at these two data points, we believe EM offers better returns for less credit risk. It is up to investors to make a macro call.

 

1. Source: Financial Times, June 15, 2018. China retaliates against US tariffs on $50 bn of imports.

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