Active Thinking

At GAM Investments’ latest Active Thinking forum, three of our brightest investment minds discussed a brighter outlook for emerging market credit, the prospect of stagnation and the role of private equity in supporting the M&A market.

15 February 2022

Richard Briggs – Emerging Market Sovereign Credit

Emerging market credit looks interesting right now for several reasons.

First, technicals look positive. Last year there was a huge rally in US equities as investors allocated heavily into the asset class at the expense of most other liquid markets. At the same time fixed income and emerging markets in particular saw outflows leaving the asset class with less in the way of fast money marginal buyers. Within both equities and credit there is a now a clear rotation from sectors which benefitted during the pandemic, particularly the tech sector, back into those which were hit during the pandemic and are now likely to benefit from a return to normality, including emerging markets.

Valuations on emerging market credit also look attractive, particularly versus developed market (DM) credit. Usually, US high yield (HY) moves in a similar direction to emerging market (EM) credit but last year EM credit significantly underperformed US HY. This has now started to change, particularly over the last few weeks as EM HY, while still under pressure, has begun to significantly outperform US HY in spread terms. Furthermore, valuations in equity and DM credit look relatively expensive, compared to EM HY where valuations look attractive. Within EM credit, there is also a real bifurcation between investment grade (IG) and HY. HY EM sovereign spreads currently trade around four times that of investment grade sovereigns, even when excluding distressed issuers, whereas in 2013 - 2018 prior to the pandemic it was closer to two times that of IG sovereigns. IG sovereigns look relatively expensive versus HY sovereigns and versus DM credit. Meanwhile, HY is looking very wide.

The fundamentals also do not look as challenging as valuations imply. There is no doubt that fiscal ratios are weaker in the wake of the pandemic. In the last three years, almost all the sovereigns in the JPM EMBI Global Diversified Index have seen an increase in government debt to GDP and primary deficits have also widened over the same period.

However, external funding ratios look stronger in many cases, particularly in the case of liquidity risk which should mean restructurings are lower that many expect. One of the indicators we focus on, the external liquidity ratio, which is reserves and dollars from exports relative to what a country pays out in short-term external debt and current account payments, has seen a fairly significant improvement over the past three years. This is in part due to countries increasing their reserves, which should provide a buffer if funding markets remain challenging.

Sovereign defaults and restructurings on external debt are typically preceded by pressure on FX liquidity and a balance of payments crisis. But at the current juncture with smaller current account deficits or in many cases surpluses, government financing needs are more able to be met by domestic lenders or via foreign exchange reserves.

External debt is also much lower relative to exports in goods and services relative to periods in the 1980s and 1990s where emerging market sovereigns saw a large uptick in restructurings. Adding to that there is not a large maturity wall for most emerging market sovereigns given they have used the past decade to term out their external debt. There are of course exceptions, Sri Lanka being one of those which is likely to have to restructure in the next twelve months, but for the most part, sovereigns are likely to be able to muddle through.

Julian Howard – Multi Asset Solutions

January was quite a dramatic month, with rising yields and rising rates, which threatened the edifice of current asset prices. We do not believe this entails a regime change and that secular stagnation remains the central theme for long term investments, but much of 2022 could see volatility.

Covid recovery is starting to run out of steam and growth is starting to slow, with inflation being the short to medium-term legacy of the Covid response. The prospect of policy mistakes this year could see the slowdown in fact worsen. The recent data release for US CPI saw a rise; we believe this will cause a continued selloff in growth factor stocks, technology, and yields going up. This rise will also shape how the Federal Reserve will respond to the perceived inflationary threat, which is a notable risk for the future. If central banks keep hammering away at inflation, then it may lead to a recession risk this year, but we view stagnation as the likely end game. The drivers of stagnation have worsened, and the pandemic has increased the prospect of a low rate environment for decades to come. According to the 2022 World Inequality report, billionaires’ share of global wealth rose the most on record in 2020. It is far better for the global economy, in terms of growth output, if wealth is more evenly spread. This makes us more pessimistic about the future.

Within equities, solid Q4 earnings mean the equity risk premium (ERP) is still in favour of the asset class. The ERP is just over 3%; in terms of the last 25 years this is fairly positive. It suggests we could be in line for a two-year compound return of just under 10% based on past data. Despite the risk-free rate going up, the earnings yield has also risen. Finally, history also shows equities eventually accept rate rises when the monetary policy tightening cycle starts.

From a capital preservation perspective, we think equities are the best form of real terms protection. There is not much in the fixed income world that can protect against serious spikes in inflation. The equity sectors that have the best pricing power score during inflation are consumer staples, communications, technology and consumer discretionary. There is no short-term way to mitigate inflation that is consistent, so for pricing power to exert itself, investment horizons must be long term.

Roberto Bottoli – Merger Arbitrage

Over the last year we have seen a rich market in terms of the pipeline of new M&A transactions, supported by strategic factors such as low rates, a brightening economic landscape globally and credits spreads under control.

At the start of 2022 things have changed marginally; we are experiencing a more aggressive stance by central banks with the possible beginning of a rates increase cycle which is a contrast to last year’s environment. Additionally, it is possible credit spreads are starting to widen, which is not as supportive for the M&A landscape. However, this is not all bad news. Rates and credit spreads only start to bite into M&A activity above certain thresholds, which we have not yet reached, and it is yet to be seen whether central banks will push rates increases to that extent. We think the 75 - 100 bps increase until June 2022 priced in by the market for Federal Reserve Funds is still a suitable level so this is not going to halt activity in the global M&A market. Furthermore, credit spreads are travelling around levels that are still below historical averages within both investment grade and high yield. As spreads are still at healthy levels, barring a big change in the economic growth scenario we are still optimistic about the chance for prolonged M&A activity.

Additionally, private equity is a very big player in the market and it has raised a huge amount of money in the last two years which has to be deployed somehow. With equity prices correcting, this means that private equity is even more willing to participate in transactions than a quarter previously. This is a factor that should further support activity in the market.

This positive picture means we have a wide universe of deals and, at the same time, spreads will not be compressed by too much activity on a small pot of names. Given the increased market volatility in general and the increased risk aversion of equity participants in the last month, spreads have risen to be 1.5% higher than at the end of the last year, which is a nice entry point.