Emerging market debt: Challenges and opportunities
- The prospect of higher US Treasury yields remains a key risk to emerging market assets.
- Geopolitical developments also pose a risk to investor sentiment and could lead to higher market volatility.
- We maintain our strategy of looking for sovereign and corporate opportunities with improving fundamentals and reasonable valuations.
The performance of emerging market (EM) debt has exceeded investor expectations so far this year, thanks to falling US Treasury yields and the persistence of broadly accommodative global monetary policies and low volatility in the capital markets. While these benign conditions could continue for some time, we think that the risks warrant a more defensive stance. That said, we still see areas of opportunity in EM debt.
Lets review the primary systemic, global risks for EM debt, along with the idiosyncratic, country-level events that have dominated the headlines. As valuations stretch and liquidity recedes, we anticipate that the market will increasingly differentiate among EM credits based on the issuers fundamental strength.
GLOBAL RATES AND MONETARY POLICY
Central banks of major developed markets (DM) have tried to suppress rate volatility and keep rates artificially low, and they have largely succeeded. In our view, intervention by the US Federal Reserve has contributed to Treasury yields that are too low given underlying growth trends. If US economic activity continues to improve, and the Feds forward guidance takes a more hawkish tone as a result, Treasury yields are likely to rise, creating a headwind for EM debt and other bond sectors.
How EM debt fares in this scenario would depend on the speed and size of the rate movement. We are inclined to expect a more muted and gradual move in Treasury yields this year than last year, when the magnitude of the rate spike prompted a wave of selling that pushed EM spreads wider.
Outside the United States, DM monetary policy generally remains accommodative, helping to sustain the lower for longer expectations of ample liquidity that have fueled a reach for yield in EM debt. While the tapering of quantitative easing and stronger US economic activity raise the prospect of Fed rate hikes, the European Central Bank and the Bank of Japan seem likely to maintain an easing bias.
Nevertheless, we believe that market perceptions of a world awash with liquidity will eventually shift. As Treasury yields rise, the carry trade driven by low yields should start to unwind, and investors are likely to become more discriminating in credit selection and less forgiving of subpar fundamentals.
REVISITING THE TROUBLE SPOTS
Escalating tensions in Gaza, Iraq, Ukraine and the South China Sea among other geopolitical flare-ups could undermine investor sentiment and instigate a return to more volatile market conditions. Earlier this year we singled out Venezuela, Argentina and Ukraine, which we called the Terrible Three because these markets all hit crisis points at the same time. How do we view these situations now?
Venezuela. We remain concerned about the ineffectual policy responses to the challenges facing Venezuela. The government is weak and torn by factionalism, and the economy is in recession and rife with shortages of consumer staples. While the devaluation of the bolivar earlier this year could have been a step in the right direction, it needed to be accompanied by fiscal and monetary restraint. Instead, increased fiscal spending and further monetary growth has fed surging inflation.
By nearly every metric, the economic and financial situation in Venezuela continues to show signs of stress and deterioration. Foreign exchange reserves are low, potentially straining the countrys ability to honor its debt obligations. Yet with the risk-on carry trade still in play, the market appears to be willing to accept the governments market-friendly rhetoric at face value. In the absence of any policy improvements, we continue to believe that Venezuelan debt dynamics are ultimately unsustainable.
Argentina. Argentina has defaulted on coupon payments to investors in its foreign-law, restructured sovereign bonds. The circumstances surrounding this technical default are unique and complicated, as it emanated from a US district courts ruling, not from impairment of Argentinas capacity or willingness to service its debt.
Though the technical default will likely have adverse implications for the countrys economic and financial conditions, Argentina has indicated a commitment to service its US dollar-denominated debt governed by local law. We believe the yields on those bonds offer reasonable compensation given current risks.
A negotiated settlement with hedge fund plaintiffs holding defaulted debt is still possible, yet we see limited scope for this in the very near term. As the outcome remains difficult to predict, we are watching the ongoing developments and continually reassessing the risks related to this fluid situation. Longer term, one bright spot is the prospect for a more market-friendly regime following next years election.
Ukraine and Russia. Tension between Ukraine and Russia has remained high, and the likelihood of a near-term resolution appears remote. The ongoing conflict has a negative impact on economic activity and, by extension, Ukraines ability to meet structural targets established in the reform program backed by the International Monetary Fund (IMF). External funding from the IMF as well as the United States and the European Union has provided a critical fiscal lifeline, yet it will almost certainly become necessary for Ukraine to obtain additional assistance. In our view, this could increase the risk of a bail-in, with private investors forced to share the burden by having a portion of their debt written off.
In response to the crisis in Ukraine, the European Union, United States and other nations have imposed sanctions against Russia, including prohibitions on dealings with certain individuals and entities, asset freezes, visa bans and limits on transactions with Russias financial, energy, defense and sensitive technology sectors. We view these sanctions as warning shots intended to dissuade Russia from continued intervention in Ukraine.
Whether the sanctions ultimately prove successful remains unclear. Even though the Russian economy could be pushed into recession, the Putin government may be willing to endure such an outcome to achieve its broader political and security goals.
For now, Russian sovereign credit metrics remain quite strong, with a balanced fiscal account, large foreign exchange reserves and a growing current account balance. Recognizing that valuations could widen to the point where they offer reasonable compensation for heightened risk, we continue to monitor the situation closely for possible investment opportunities.
AREAS OF OPPORTUNITY
We believe that when capital markets become more discriminating, divergent fundamentals among EM countries will make differentiation the key theme of country and security selection. In particular, the full valuations of low-spread, high-grade sovereigns suggest vulnerability to higher Treasury yields. And we suspect that if market liquidity recedes, investors may punish higher-yielding, lower-quality sovereigns where fundamentals have deteriorated and the outlook is unfavorable.
In this environment, we have focused on finding opportunities in sovereigns, quasi-sovereigns and corporates that offer stable to improving fundamentals and reasonable valuations while also providing some insulation against the risk of rising Treasury yields. Our goal has been to stay disciplined, looking to reduce exposure as valuations become rich or fundamentals weaken.
Areas of opportunity still exist within EM debt, yet after solid gains in bond prices, valuations in aggregate appear less attractive now than in early 2014. As US dollar-denominated EM sovereigns and corporates have recovered their losses from 2013s taper tantrum, risk/reward relationships have become less compelling, leaving us with modest expectations for the performance of EM debt for the rest of the year. Nevertheless, we believe that relative to many other fixed income assets, EM debt valuations are not as stretched.
Although local currency EM debt has yet to fully recover from last years selloff, we believe that EM currencies may have the highest beta to possible global financial turmoil, given their liquidity and the need for additional macro adjustments in certain EM countries.
In our view, with asymmetric risk to both interest rates and credit spreads, as well as geopolitical and idiosyncratic risk, this is an environment that calls for exercising caution when investing in EM debt. We believe in being positioned defensively for possible repricings of both Treasuries and risk that is, higher yields and wider spreads.
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