Emerging Market Debt (EMD) has performed well in the first half of 2017. We expect the supportive environment to stay in place and remain constructive given improving fundamentals and still supportive valuations. At Stone Harbor, we believe the best approach to investing in EMD is to concentrate on the most attractive opportunities across all sectors: hard currency sovereign, corporate and local currency debt.
EM hard currency sovereign debt has been one of the best-performing fixed income asset classes over the past 10 years and continues to outperform other fixed income assets with favorable risk adjusted returns.
Improving Fundamentals
EMD continues to evolve as an asset class and has become an integral part of diversified portfolios. There are good reasons for this development. EMs account for 40% of global economic activity and, despite a slump in recent years, EM growth continues to outpace developed market growth by a wide margin. With EMs creating large economic value in our view, not investing in EMD means foregoing valuable opportunities to diversify and generate performance.
EMD has also proven itself a robust asset class, performing well over the cycles. The improvements in EM policymaking – including independent central banks, flexible FX regimes, and stronger fiscal frameworks – have played a big role in this development. Consequently, EM hard currency sovereign debt has been one of the best-performing fixed income asset classes over the past 10 years, and continues to outperform other fixed income assets with favorable risk adjusted results. Encouragingly, performance of EM local currency debt has also improved following a repricing period during 2013-2015.
We believe that improving growth in many EMs
and attractive valuations have created investment opportunities in EM currencies, local interest rates and hard currency sovereign and corporate debt.
Beyond the arguments for long term strategic allocations to EMs, investors must decide how and when to invest in the various sectors within EMD. At Stone Harbor, we look to both economic developments and market valuations to answer these questions. In the current environment, we believe that improving growth in many EMs and attractive valuations of select assets in many countries have created investment opportunities in EM currencies, local interest rates and hard currency sovereign and corporate debt, particularly when compared to developed market fixed income.
Poised for Growth
The dominant economic theme over the past five years has been the growth slowdown, and the impact on EMs has been keenly felt given the lower commodity prices and a reversal of capital flows. We see evidence that this process bottomed last year. EM growth and export indicators have turned positive and expectations are being revised higher for the first time in five years.
We are still far away from the exuberant optimism towards EMs following the global financial crisis, but markets have overcome the deep pessimism after the “taper tantrum” of 2013.
EM currencies have experienced large adjustments and remain far below their pre-2013 levels. As a result, we already see improved competitiveness in the form of stronger current account balances. EM inflation appears to have peaked and the interest rate cycle is turning lower, helping to reinforce the growth trajectory of EMs. In other words, we believe much of the pain associated with the currency adjustment is built in, and EMs are positioned to take advantage of their strong long term fundamentals.
In contrast, advanced economies remain troubled by low productivity, weak demographics, sluggish demand and low interest rates. Monetary stimulus might be withdrawn, but the lack of inflationary pressure means this process likely will occur gradually. Looking forward, high global savings combined with sluggish investment demand may keep real interest rates low.
As concerns about President Donald Trump’s protectionist policies abate, we believe EMD should continue to perform and attract inflows. We are still far away from the exuberant optimism towards EMs that prevailed in the early post-global financial crisis years, but markets have overcome the deep pessimism following the “taper tantrum” in 2013.
Identifying Value
Relative to other fixed income asset classes, EMD valuations are relatively attractive to us.
This brings us to the next step in assessing investment opportunities in EMD: valuations. Currently, fixed income investors are struggling to find attractive investments in a world of low interest rates. Asset valuations, in both fixed income and equities, are at best fairly valued by historical standards.
In this context, EMD valuations are relatively attractive to us, compared with other fixed income asset classes. Despite tighter spreads since early 2016, hard currency sovereign spreads remain compelling. U.S. corporate bond spreads have tightened close to post- global financial crisis lows. In developed Europe, the opportunities are even more limited; nearly 60% of the European high yield bond market trades at yields of 3% or lower. In contrast, many EM corporates trade at wider spreads in nearly every rating category compared to similarly rated U.S. or European corporate credits.
In local currency debt, valuation levels are more complex due to the FX component. Nevertheless, EM currencies have adjusted sharply lower in recent years. Though many EM currencies have appreciated from their 2016 lows, we believe they remain attractively priced and have room for improvement. In addition, real rates in several EMs remain high given that many EM central banks had hiked policy interest rates aggressively in the past several years to combat fears of inflation.
Summarizing, all EM countries and regions are not created equal. With varying valuations, FX, inflation and monetary policy and political climates, the disparity means divergence across the asset class and opportunity for nimble managers.
Managing the risks inherent in most higher-yielding EM countries requires in-depth research and experience. We see this variation of opportunities within each sector of EMD: hard currency sovereign, corporate, and local currency debt. Thus, we believe the best approach is to concentrate on the most attractive opportunities across all sectors of EMD. At Stone Harbor, analysis of fundamentals and the market environment, rather than benchmarks, dictate our investment preferences.
Seizing Global Opportunities
We have learned over the past several decades that a flexible, active asset allocation approach, grounded in fundamental credit analysis, is the most reliable means of identifying attractive risk-adjusted returns in EMs. We also believe this approach provides conviction in volatile markets when other investors may be less certain or less informed.
Russia provides a good case study of the potential opportunities that derive from this approach. In the latter half of 2014, market volatility related to the sharp decline in crude oil prices and fears of the economic impact of the conflict in Ukraine led to depreciation of the ruble and sovereign credit spread widening. Based on the falling prices of Russian assets at the time, few investors were adding risk in Russia.
We have learned over the past several decades that a flexible, active asset allocation approach, grounded in fundamental credit analysis, is the most reliable means of identifying attractive risk-adjusted returns in EMs.
Russia, however, had one of the lowest debt ratios of any country globally and high international reserves that served as a significant source of repayment capacity. Changes in policymakers at Russia’s central bank and in the Ministry of Finance’s debt liability management team were reassuring. A depreciating ruble initially provided an opportunity to add local currency exposure, while spread widening provided an opportunity later to purchase Russian sovereign U.S. dollar-denominated debt. As the sovereign spread tightened again in 2015, resilient oil and gas and telecommunications credits offered attractive investment opportunities. Later in 2015, market fears of Russian capital flight subsided and the currency began to strengthen, signaling an opportunity to reduce exposure in local markets in favor of concentrating in external sovereign and corporate debt.
Fast forward to today and Russia’s credit markets appear to offer less value based on our view of both fundamentals and valuations. Russia hard currency sovereign and most of the country’s corporate debt trade at tight spreads both historically and relative to comparable global credits, in our view. As a result, investors may find that Russian U.S. dollar- denominated assets achieve lower potential total returns than the same bonds earned a couple of years ago. However, certain opportunities remain, such as the Russian ruble, which we believe is supported by a hawkish central bank and steadier oil prices.
Russian U.S. dollar- denominated assets likely will achieve lower potential total returns than the same bonds earned a couple of years ago. We see much better opportunities today in Ukraine.
In contrast to Russia external debt, we see much better opportunities today in Ukraine. After visiting Ukraine twice in recent months, we came away with renewed confidence in the current government’s ability to pass pension reform and other legislation that are important conditions for continued support from the IMF, which has provided a $17.5 billion support program. Ukraine’s economy is benefiting from this lending aid and renewed foreign direct investment. The U.S. and much of Western Europe have strong geopolitical reasons to ensure economic recovery in Ukraine, in our view. We believe these factors improve the sovereign’s capacity to repay its external sovereign debt which trades at attractive valuations.
Complementing our sovereign views, we also believe the top tier of the Ukrainian banking sector will benefit from an improving economy.
Latin America is currently our highest conviction region as growth is recovering from cyclically low levels in several key countries. We like Brazil, Mexico and Argentina, each of which offers high real rates and favorable inflation dynamics. In Brazil, we see opportunities in each sector of EMD. While Brazil’s fiscal deficit remains a key concern and the necessary adjustments are likely to occur slowly in the current political environment, we are encouraged by the quality of leadership at the ministry of finance and in the central bank. We believe the central bank of Brazil has room to ease monetary policy as disinflation takes hold, providing attractive capital returns on local bonds. In addition, investment opportunities exist in external sovereign debt in which spreads remain too wide, in our estimation, relative to the sovereign’s high level of international reserves and the government’s reform momentum.
Brazilian corporates have been negatively impacted by the ongoing corruption scandals around various political and business leaders. The most recent scandal, which allegedly included bribes of the current President Michel Temer when he ran for office as vice president in 2014, has exposed the inefficiencies that previously plagued Brazilian industry. While political unrest related to these allegations have caused dislocation in the pricing of Brazilian corporate risk in the short term, we believe that the long term result of efforts to reduce corruption will include high standards for corporate efficiency and governance. Consequently, investors may find value in the debt of companies that are best positioned to benefit from these changes, including the national oil champion and credits in the agribusiness sector.
Latin America is our highest conviction region as growth is recovering from cyclically low levels in several key countries. We like Brazil, Mexico and Argentina, each of which offers high real rates and favorable inflation dynamics.
Mexico was shunned in the run-up to and following President Donald Trump’s election, with the prospect of tougher trade policies denting the enthusiasm of many. So far in 2017, the U.S. administration’s rhetoric on trade has been less aggressive than feared. We believe the benefits of the North American Free Trade Agreement – including stronger growth, millions of jobs, lower prices and the quadrupling of trade between members – means President Trump will not “tear up” the agreement, even if talks are ongoing. Growth is steady and poised to improve, offering good opportunities at fair valuations going forward in sovereign debt denominated in Mexican peso and in U.S. dollars.
Over the last several years many Mexican corporates have evolved into global players serving a worldwide customer base, especially in the consumer products, cement and petrochemical sectors. Significant U.S. operations shield many of these companies from U.S. protectionist threats, supporting our positive view.
In Mexico, growth is steady and poised to improve, offering good opportunities at fair valuations going forward. Argentina has been a major turnaround story, as inflation and interest rates have fallen.
Argentina has been a major turnaround story. After a series of defaults, the country’s credit quality has improved under the tenure of market-orientated President Mauricio Macri. Inflation and interest rates have fallen as the government ended currency controls and the independent central bank initiated a strict inflation-targeting regime. Capital markets have deepened after the issuance of $16.5 billion worth of bonds last year. With Euro-denominated sovereign spreads trading near 700 basis points, we believe investors are being richly rewarded, particularly when compared to similar U.S. dollar-denominated bonds from Argentina.
Following the sovereign default in 2001, Argentina’s economy was beset with a web of regulated, and often contradictory, price schemes for many basic commodities such as fuel, natural gas and electricity. In many cases, prices were frozen at levels from before the default and subsequent peso devaluation. As a consequence, the Argentine economy saw a prolonged period of underinvestment in oil and gas exploration, power generation capacity and other crucial infrastructure. As the current administration has adopted more orthodox economic policies, Argentine corporates have regained access to U.S. dollar capital markets to fund expansion plans. We have identified several investment opportunities that are targeted to address Argentina’s natural gas deficit (“Plan Gas”) and to integrate natural gas and energy generation.
We have identified several investment opportunities that are targeted to address Argentina’s natural gas deficit (“Plan Gas”) and to integrate natural gas and energy generation. We are also optimistic about Egypt; we believe the country is finally embarking on a multi-year run following the Arab Spring.
Elsewhere, Egypt is another optimistic story. The election of General el-Sisi in May 2014 has restored political stability and, since adopting an IMF package, economic confidence is rising as well. Rating agencies have welcomed the gradual elimination of fuel subsidies. In our view, the recent devaluation of the Egyptian pound should support the country’s economy. The country is opening its high-yielding local bond market again for international investors while growing international reserves provide a buffer for changes in capital flows. We believe Egypt is finally embarking on a multi-year run following the volatility of the Arab Spring and see value in local treasury bills.
Overall, we believe today’s EMD markets offer more stable access to yield in a growing asset class with a strong fundamental backdrop.
Finally, we believe investors can find pockets of opportunity in smaller markets in Sub- Saharan Africa (SSA), particularly the Ivory Coast, among several others. The opportunity in this region has developed recently in response to oil price volatility. Bonds from several SSA countries became extremely cheap as oil prices fell in May and June. Yet behind the scenes there are some positive reforms being undertaken. Abdourahmane Cissé, Ivory Coast’s budget minister and a Western-trained banker, has helped turn the country into one of Africa’s best performing economies. Collapsing cocoa prices – Ivory Coast is the largest exporter in the world – have applied some pressure on the country, but diligent leadership and prudent policies have continued to deliver high growth at around 7.5%.
In the SSA corporate sector we see value today in the oil sector in Ghana and in telecommunications infrastructure in Nigeria. Nigeria has supportive demographics (population of 180 million), but telecommunications services are still relatively undeveloped. We believe that demand for telecommunications and data services is expected to increase, requiring more infrastructure investment. Further, we expect consolidation in Nigeria’s telecommunications market which should allow for more profitable service providers.
Summary
Overall, we believe today’s EMD markets offer more stable access to yield in a growing asset class with a strong fundamental backdrop. In 2016, we were forecasting GDP growth to reach 4.4% and over the last four months have increased our growth expectations to 5.0% as the economic outlook improved. We believe this improving outlook also explains the strong performance of EMD since the U.S. Federal Reserve started hiking rates, as EMD offers improving fundamentals and a valuation cushion to withstand rising U.S. rates.
By Stone Harbor Investment Partners
