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Published on: 27 Mar 2017 by francisjud
Emerging market (EM) debt has seen a sharp sell-off since
the US elections. What is your outlook for the asset class? EM debt needs
growth, and in theory strong US growth (i.e. fiscal expansion) should be
positive for the asset class. The uncertainties around a Donald Trump
presidency are well known, especially on the global trade front, and this
explains some of the sell-off that we’ve seen in EMs since the US elections.
However, I think the markets may be overestimating the extent of trade
protectionism by pricing in potential moves such as the North American Free
Trade Agreement (NAFTA) being cancelled, but the important thing to note is the
fact that EMs benefit from strong global growth and we should see this in 2017,
especially with stabilising commodity prices.
This is particularly good news for local yields, which
are around 6.5%-7%, and in some of the higher yielding dollar universe, for
example Argentinian US dollar-denominated debt. EM debt is also less affected
by rising bond yields than traditional fixed income. Another concern is that if
US interest rates move significantly higher, then EM debt won’t look as
attractive as an asset class. Finally, higher US interest rates will also
directly increase borrowing costs for EM countries – although US dollar debt is
becoming a smaller portion of overall EM borrowing and dollar debt levels are
in general more manageable now.
Despite all this uncertainty, it is important to note
that EM countries are actually in pretty good shape. Overall fundamentals for
EM as an asset class are stabilising, and this is after a number of years when
fundamentals were deteriorating. This has been driven by external factors, such
as the dissipation of the commodity price shock and the improving global growth
picture. It has also been driven by the improving credit stories of countries
like Brazil, Argentina and Russia.
Overall, I am quite optimistic and I think 2017 will be a
year where we can take more opportunities and less of a defensive stance, with
What could be the
impact of fiscal expansion in the US?
President-elect Trump intends to give the US economy a
shock of fiscal stimulus that I do not think it needs at its current point in
the financial cycle. There could be a boost to growth, from around 2% to
2.5%-3%, but because of the tight labour market there is an inflation risk.
However, the hope is there will be enough global spare capacity that prevents
this from becoming an issue – if not, the US Federal Reserve (Fed) would have
to raise rates faster than the markets anticipate.
How do you see
current valuations in EM debt?
Local yields are, in absolute terms and relative to
developed market yields, attractive. Inflation is coming down, which should
also support EM bonds. This is because EM central banks can now ease monetary
conditions; something they haven’t been able to do in a long time.
With hard currency bonds, we’re seeing more of a
bifurcated market. You have the high-quality investment-grade countries, like
Mexico and Brazil, where you get very little yield. If the US Treasury curve
normalises further, these countries will have very little yield cushion to
protect against a rise in US interest rates, which is not particularly
attractive. However, in the dollar space, there are some higher yielding bonds,
such as Argentina and some Sub-Saharan African countries, where yields are
significantly higher. We see these as more attractive because you take a lot
more credit risk, or spread risk, rather than underlying US interest rate
What is your
outlook on EM currencies?
If we look at our fundamental equilibrium value exchange
rate (our internal
fair value exchange rate model), overall, EM currencies still appear
undervalued, and they have very attractive carries because of high inflation
rates. Even those fair valued currencies like the Brazilian real have large carries,
which provide lots of cushion, even if the currencies depreciate slightly.
Whether or not we see EM currencies appreciate from here, however, will again
depend on what a Trump presidency looks like. We may see the dollar move higher
if we have meaningful fiscal expansion in the US, but I think it will be
different from when the Fed was withdrawing quantitative easing or planning its
first rate hike. At that time, this was done in an environment of disinflation
and a lack of growth in the rest of the world. Now we have a recovery in Japan
and Europe, with strong employment growth. I do believe that EM currencies are
cheap enough to allow for some uncertainty.
What’s your view
on commodity prices?
Based on the views of our commodity specialists, I would
expect commodity prices to be well-supported and rangebound. There is still a
lot of supply, but with a better growth picture, demand should not only
stabilise but also increase somewhat.
Could you share
your outlook for China?
There are several interesting things happening in China.
Firstly, the government is working to depreciate the renminbi because it does
not want the currency to appreciate any further against the Japanese yen, which
the Japanese government is also trying to weaken. Plus, there is a slightly
stronger US dollar outlook, at least for the next 6-12 months.
Secondly, Chinese growth received another artificial
boost earlier in 2016 through fiscal stimulus, but this is now beginning to run
out, meaning growth is coming down to its structural run rate of around 4%-5%.
Finally, the very positive news is that China has come
out of its deflation trap – producer prices have been positive for the first
time in three and a half years – which has increased its nominal GDP growth.
So, yes, there is a structural slowdown, partially due to poor demographics,
and we don’t expect any further stimulus, but the presiden
What about the
problem of nonperforming loans in China?
There are lots of non-performing loans in China, which
could be problematic, but because the country has a closed capital account and
a banking system that is state-owned, then it should take a lot longer to
become a problem, if at all. With time and money, you can defer those issues or
just remove them through inflation; if your economy is growing well in nominal
terms, these non-performing loans become a lot less of a problem.
What are your most
compelling investment opportunities right now?
Brazil and Argentina are both examples of countries
where, following a decade or so of economic mismanagement, we are finally
seeing some change. Brazil has a strong technocratic caretaker government, with
a president that is not planning to run for re-election.
This means that President Michel Temer can do the hard
work and put the country on a much better footing, including cutting the budget
deficit, which should also allow for lower interest rates. Hopefully, by the
time of the next election in 2018, the economy should be doing better and the
population might be in a better position to elect a government that will have a
mandate to really improve the country’s economy
Argentina is in a similar position. After 12 years of
Kirchner governments, the country finally has a conservative, orthodox
centre-right government in place, which is looking to undo the distortions in
the economy (although this will take time).
With Russia, while the political landscape has not
changed much, the government has at least been very pragmatic in its economic
approach by letting the rouble fall to compensate for declining oil prices.
India is also delivering nicely on some reforms. Growth has been good and
inflation is coming down.