13 September 2018
Emerging market local currency bonds have faced a series of headwinds so far this year including political risk, US tariffs and sanctions; yet, GAM Investments’ Mike Biggs believes the outlook is positive due to sound economic fundamentals.
Emerging market local currency bonds have had a difficult year so far. Recent weakness has been very different from that observed in Q2, when the US dollar strengthened and EM weakened in response. In contrast, EM weakened by more than one would expect in August given the moves in the dollar.
In our view, the divergence has been due to idiosyncratic risks (Turkey, Argentina), political risks (Brazil), US tariffs and sanctions (EM generally and Russia specifically), and arguably some contagion.
Despite the disappointing performance so far, we continue to think the outlook for EM local currency debt is positive, due to sound economic fundamentals coupled with attractive valuations.
Two fundamentals on which we place particular emphasis are the growth outlook and the balance of payments – both of which remain solid in our view. EM growth was weak from 2011 to 2015 because credit growth was falling. As soon as it stabilised in 2016, the credit impulse picked up and GDP growth increased to above 4%.
Credit growth remains low relative to history and below nominal GDP growth: in other words, the EM debt-to-GDP ratio is falling. We expect credit growth to rise until it is at least in line with nominal GDP growth and, while it does that, the positive credit impulse should be supportive of real private demand growth.
To be bearish on EM growth, one has to expect EM credit growth to decline from already subdued levels. While this is always possible in the short term, it is difficult to see further declines being sustained. In our view, the growth outlook is as good as it has been for the past three years – and when EM growth is strong, EM assets tend to perform well.
Graph 1: EM nominal GDP vs credit
Past performance is not indicative of future performance.
The balance of payments outlook has become more difficult of late. Until Q2, EM’s current account balance seemed to have returned to surplus, capital inflows picked up and EM FX reserves were rising. Growth in EM FX reserves tends to be correlated with strong EM FX performance.
Although capital inflows into EM picked up through Q1, they remained low relative to history. Our expectation was that the current accounts would remain stable, capital inflows would increase further and EM FX would be supported by the resulting growth in FX reserves.
EM FX reserves peaked at the end of Q1, however, and EM FX has come under pressure as reserves fell in Q2 due to softer portfolio inflows and a deterioration in EM’s trade balance.
The aggregate deterioration in the EM trade balance misses some interesting underlying trends, however. The weakness is all in Asia, and led by non-GBI-EM members Korea, Taiwan and India. In the rest of EM, the trade balances continue to improve.
Graph 2: EM ex-Asia trade balance
Past performance is not indicative of future performance.
In the coming months, we expect the EM trade balance to remain solid and to improve in those countries that have suffered idiosyncratic negative shocks (Argentina, Turkey). If the US dollar stabilises as we anticipate, we expect capital inflows into EM to resume, attracted by strengthening growth and high yields.
In short, we believe low levels of current credit growth bode well for the future growth outlook and the low current levels of capital inflows limit the downside to EM FX.
- Credit growth: EM credit growth was 22% at the start of 2008 and 12% at the start of 2013. In both cases it was elevated and well above nominal GDP growth and therefore more vulnerable to a decline. At present credit growth is only 8%, well below nominal GDP growth. As a result, we believe the risks of a decline are lower.
- Capital inflows: EM FX tends to rally when capital inflows increase and fall when capital inflows decline. As the flows data shows, capital inflows were USD 110 billion in 2008 and USD 90 billion in 2013. It was very easy for capital inflows to decline from these levels and, when they did, the FX came under pressure. At current levels of around USD 30 billion, we believe the risks of a substantial decline are lower.
- Current account: By the middle of 2013, the aggregate current account deficit for our sample of countries was USD 54 billion. At present it is barely USD 1 billion.
- Yields and exchange rates: In 2013, yields on the GBI-EM had fallen to historically low levels of 5.2%. Current yields are 6.73%, which is in line with the historical average. In both 2008 and 2013 EM real effective exchange rates were at their historic highs; now, in contrast, EM exchange rates are cheap on most measures.
While the EM fundamentals are stronger at present, we believe a number of risks still exist:
An ever-present risk to EM local currency debt is US dollar strength and this was the source of EM weakness in Q2. In our view, our best bet is for the dollar to move sideways from current levels. The interest rate differential favours dollar strength, but robust global growth and the deterioration in the US fiscal balance argue for dollar weakness.
Trade wars, sanctions, idiosyncratic risks, political risks and contagion
- Trade wars: The deterioration in global trade relationships between the US and the rest of the world is negative for EM and has likely played a role in the poor performance year-to-date. In the short term at least, increased trade tariffs by the US and the response by the affected countries is negative for the US. This is evident in the way US tariffs on goods like washing machines caused the washing machine price to spike in the US and retaliatory tariffs on US soybeans by China caused the US soybean price to fall.
In our view these economic negatives should have an impact on trade negotiations at some point and move the US administration towards a negotiated solution to the current disputes.
- Sanctions: While the tariff debates impacted on all of EM, US sanctions specifically impacted on Russia. In our view the worst is past here and – critically – sanctions on holding Russian sovereign bonds are unlikely. However, it is difficult to have conviction on the US policy outlook at present.
- Political risks: The most imminent in this respect is Brazil, with presidential elections due in October. We are positive on Brazil from a macroeconomic perspective and all leading candidates (regardless of their place on the political spectrum) appear to recognise the need for pension reform and fiscal adjustment. We are positive on the medium-term outlook for Brazil but in the near-term the market could struggle if a more left-leaning candidate looks likely to be elected.
- Contagion: There appeared to be an element of contagion in August, where countries with sound fundamentals appeared to struggle on the back of weakness in Turkey and Argentina. In our view this might have been partly due to lower volumes during the summer lull and we expect the fundamentals to win out in the coming months.
In aggregate, we believe these risks are now largely priced in. Furthermore, sound fundamentals mean EM is far better placed to weather these than in the past.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.