Standish sees revival in demand
Inflows into US high yield bonds and high yield loans demonstrate strong demand for credit. We think emerging markets credit (US dollar-denominated sovereign and corporate bonds) will be part of this trend in 2014, unless there are fundamental problems in emerging market countries. We continue to see increasing interest on the part of institutional investors in emerging markets debt (EMD), not least as EMD valuations have become more attractive as a result of the sell-off in the summer of 2013.
We acknowledge some foreign investors in emerging markets local currency denominated bonds have been finding the currency volatility too much to tolerate. Demand for such bonds from local financial institutions (pension plans, banks, mutual funds) has not been enough to mitigate the price effect of foreign sales, even though local institutions, on average, still own more than a half of the market. However, in our view, local demand will ensure a quick recovery to more fundamentally justified levels, once the dust settles from the foreign sell-off. This was the pattern seen in the immediate aftermath of the Lehman Brothers crisis.
Driving force of liquidity
The phrase EMD belies the diversity of the underlying risk exposures. We prefer to think instead in terms of bonds issued by entities located in ‘non-rich’ countries. Such non-rich countries may be on different economic trajectories, often pursue distinct monetary and fiscal policies, and possess unique strengths and vulnerabilities. Among non-rich countries, we can find very open economies (e.g., those of Poland and the Philippines) that are substantially affected by global trade flows, and fairly closed ones (e.g., India, and Brazil). There are plenty of commodity exporters but there are also commodity importers.
Among non-rich countries, some have poor creditworthiness but the majority of such countries are now of investment-grade quality. Similarly, their bonds come in different varieties. As such, formulating a single outlook for such a heterogeneous asset class as EMD is a difficult challenge.
The extent to which investors treat EMD as a single asset class has been affected by flows. For the past several years, flows have been very supportive of EMD, with inflows encouraged by the aggressive loosening of monetary conditions and the debt overhang in developed countries, as well as by the promise of higher growth rates in emerging economies.
Turning off the tap
In May 2013, inflows stopped abruptly (and, in fact, went into reverse) as the US Federal Reserve (Fed) signalled it would start tapering its asset-purchase programme. The surprise in May was not that the Fed would consider changing its course (hardly anyone expected the Fed to continue injecting liquidity indefinitely) but that it came so soon and in the absence of the more convincing signs of a US economic recovery. As a result of this major shift in expectations, US Treasury yields sold off aggressively.
EMD is certainly not the only asset class that previously benefited from a sea of liquidity. However, we believe it has suffered more than others in the latest sell-off due to its relatively high duration and the perception that the emerging markets growth story has recently lost some of its lustre. While non-rich countries will likely continue to grow at faster rates than that of their rich, developed counterparts, we believe slower growth in China and policy imbalances in Brazil, Turkey and elsewhere have unnerved some investors.
Re-emergence of value
While EMD has just gone through a testing period, value has re-emerged across its various segments, especially EM US dollar-sovereign debt, ‘crossover’ corporates (previously widely owned and most recently heavily sold by global fixed-income managers), local currencies and rates. In risk-adjusted terms, EM US dollar-denominated debt (broadly defined) presents the most compelling value, in our opinion. However, EM local currency debt has more potential in the long run. It also offers value, with yields now higher than on US high yield debt when, historically, they have been lower.
While EM currencies have priced in higher US Treasury rates, they have not yet priced in the improved economic environment in the US that rebound in the US economy is positive for emerging market exports and growth. We therefore expect some appreciation of emerging market currencies against the US dollar over the next 12 months. At the same time, we also expect volatility.
By and large, weakness in emerging market currencies is not producing detrimental effects. In the past, the depreciation of emerging market currencies would affect the debtservicing capacity of emerging market sovereigns (and corporates), with heavy liabilities denominated in an external currency. The improvement (in most cases) of sovereign balance sheets over the past decade has greatly reduced this pernicious effect.
In our view, stabilisation in US Treasury yields is a prerequisite for a rebound in EMD in 2014. While we expect US Treasury bond yields to drift higher, the ripple effect on EMD is likely to be less pronounced than that experienced in more recent times.
- Local demand should underpin local currency bonds
- EMD should surmount the ripple effect of rising US Treasury yields
- We remain wary of market sentiment and expect some volatility