Focus on: emerging markets fixed income
In 2016, tightening US monetary policy and collapsing commodity prices were something of a spanner in the works for emerging markets. Does 2017 offer better prospects for fixed income investors? Here, managers from Newton, Standish1 and Insight consider opportunities in the world’s emerging markets for the next year.
What do you see as the biggest tailwinds for emerging markets (EMs) in 2017?
Javier Murcio: The past year has proven the asset class can deliver attractive returns for fundamental reasons, not just technical ones. The commodity price outlook has improved and EM economies should be able to grow fast again in 2017 as the recovery in commodities provides more stability for the external accounts of these countries. Global interest rates and commodity prices remain the main drivers of this asset class and lower rates going into next year will provide another tailwind.
Carl Shepherd: Probably that Chinese growth is higher than was previously expected. A firming up of oil prices has also helped stall the slide in commodity EM currencies. A free-falling currency imports inflation, facilitates rash decision-making and makes planning an economy more difficult. This perhaps doesn’t constitute a tailwind but it is certainly a stabilising factor, which makes the carry trade attractive again. Lastly the reassessment of the pace of US rate rises we think is a help, i.e. the Fed was less hawkish than was expected in early 2016 and continues to appear that way.
Colm McDonagh: Fundamentally we think emerging market growth is improving, particularly in some of the larger developing economies as they recover from the growth shocks we’ve seen in recent years. Secondly, a number of EMs have engaged in fresh economic reform. There’s also no doubt the opportunity cost of investing in emerging markets is currently very low. This was definitely a technical driver behind some of the investment inflows we saw in 2016.
Is political risk a factor for the coming year? If so, which countries/regions present the biggest risks and why?
Javier Murcio: In our investment universe, there are always elections somewhere. The outcome of the US election was important, particularly for trade policy. There are a lot of elections in Europe between now and the end of 2017, so political risk is always part of the mix. Russia's involvement in the Middle East could have implications for central and eastern Europe and Turkey, for instance. Brazil faces a very important vote in congress some time in the first half of the year. Local elections in Argentina will be important signals of how much support the administration there has.
Colm McDonagh: Politics in developed markets will probably be the dominant driver of asset returns in the short term. Brexit, the aftermath of the US presidential elections, ongoing discord in the Middle East and relations between Russia and the West all have the potential to influence markets, including the EM sector. Notwithstanding the varied politics throughout emerging markets, we see the current electoral cycle across these markets as less of a cause for concern than the picture in more developed markets.
Carl Shepherd: Political risk is certainly a factor. Aside from the very specific idiosyncratic risks to individual countries with weak institutional frameworks, the bulk of political risk lies in the developed world. The US election is now behind us, but we will get a better idea in 2017 how far the new president is actually going to go in enacting policy, which could threaten globalisation and free trade.
Right wing parties and populists have increased the fractiousness of the EU, and the three largest economies within the EU are experiencing significant political events: elections in Germany and France and the UK is expected to trigger Article 50 to begin negotiations to leave the EU. Added to this, Japan and China both need to decide whether to stick to their current monetary policies or consider alternatives. Therefore any of these items have the ability to engender a ‘risk on’ or ‘risk off’ dichotomy or affect global trade, investment and confidence for the better or worse.
Will the US retreat from globalisation and what could this mean for EM?
Javier Murcio: Political pressure is there but free trade is already embedded in the way businesses operate in the US. We may not see further liberalisation by the US but several other countries are doing treaties with Europe and China. We’ll also continue to see China’s influence grow and not only in Asia. In Latin America for example, China now counts for at least a third of trade in many countries. This reflects the influence of commodities. but also influence through investment. The rise of China reorders the world as we know it but I don't think of that as a risk.
What’s the outlook for issuance in the coming year? Do you think the commodities recovery will affect borrowing?
Javier Murcio: Issuance through 2016 was slower than expected for a number of reasons. Some countries are able to pre-finance themselves and don't need to go to the market. Local markets are major sources of funding now. Those factors that inhibit issuance are partly balanced by big re-entries into the market by Argentina and Saudi Arabia, one of the most welcome developments in capital markets in a long time.
Carl Shepherd: The market will be very wary. If you drew up a winners and losers list from likely Trump foreign policy, Saudi Arabia would be on the losers list. For the moment, they are able to spend money they already have to plug any gaps and won’t want to issue into weak demand for EM debt. Issuers will be in a wait-and-see mode and probably only the very desperate will issue early in 2017. Should things prove to be not as bad as anticipated then there may be a rush for issuance later in the year.
From what we can estimate from economic policy it will likely be inflationary, we can see this from the sell-off in US Treasuries. That is only going to push yields higher in EM debt, thus increasing the cost of borrowing and issuance.
Colm McDonagh: In the coming year we expect more issuance to come from sovereign markets and corporate issuance to remain subdued. The fact that major issuance has come out of the Middle East (Qatar, Saudi Arabia) reflects what has happened in the commodities sector and the cyclicality of economies in the region. Yet such major issuance also creates a larger investment universe for emerging market debt funds and increased investment opportunity.
Elsewhere, we continue to see new markets opening up. Access to the Chinese domestic market is becoming easier and we expect we will see continued progress in accessing the Indian onshore government bond market. In the United Arab Emirates we expect to see further development of the local currency market, while Argentina is creating a tradable domestic bond curve.
What’s your outlook for investor inflows/outflows in EM debt for the coming year?
Carl Shepherd: Inflows have been particularly strong in the hard currency space for EM in 2016. If the US Fed remains reasonably dovish in 2017 and commodity prices hold up then I expect flows to remain robust but with a greater allocation to local currency debt. The local currency indices are deeper, more liquid markets and have a higher rating. The last commodity downturn had a weakening effect on EM currencies, even as future inflation expectations increased. Therefore we could expect another round of domestic rate increases to counter this – which would result in yields rising and therefore prices falling.
Colm McDonagh: We have a fundamental belief we will see investment inflows come back into emerging market debt but we also believe the mechanism by which people make that allocation is shifting. Already there is evidence of long-term strategic flows coming back into the market. But most institutional investors are currently trying to figure out how they access EM fixed income, without some of the volatility we have seen in recent years. For a number of reasons – including the rally in EMD we have seen this year – there will be those who invest in emerging markets as they have done many times in the past.
1. Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.This is not investment advice. Regulatory Disclosure