Beginning this week, the sun officially sets before 4:00pm in London, leaving the city in darkness for most of the day. While this may sound bleak and depressing, the city has simultaneously come alive as the streets and squares are strung with lights, signalling that the holiday season is upon us. Observing this stark contrast of dark days and bright lights, I can’t help but think – where is the light amidst the emerging markets darkness?
The weaknesses in the emerging markets debt space have been well publicised: slowing growth, significant exposure to the deterioration in the commodities sector, weak exports, negative impact from weaker currencies, geopolitical risks – the list goes on. However, at the index level the sector has actually held up better than most would have expected (at least for the USD-denominated sectors) and is even outperforming many of the other fixed income and equities sectors year to date.
However, as we constantly stress in EMD, differentiation is key. Looking under the hood of the index, what has been the “light” driving the solid performance of the sector this year despite the apparent darkness in emerging markets? As the below graph shows, the majority of the strong performance on the USD-denominated sovereign debt side has been driven by Russia and Argentina: Russia, which constitutes 5% of the index, has returned 11% year to date while Argentina, which is 2% of the index, has returned 20% year to date.
So what has been going on in these countries that have led to their strong performance? If we look at Argentina, political dynamics have been the primary driver of performance. Despite negative fundamental factors (including declining reserves, high inflation, and low growth) the country’s bonds have rallied throughout the year in anticipation of the shift in political regime away from the incumbent president Cristina Kirchner. Much of this rally actually took place before the final election results, as both of the candidates (Mauricio Macri and Daniel Scioli) were viewed as market-friendly. While the presidential change has been taken positively by the markets, it’s now time for the actual adjustments (fiscal, monetary and exchange rate) to be made, which is no small undertaking. Regardless of whether Macri is successful in implementing the necessary reforms, it’s safe to say that Argentina’s bonds won’t have the same support of political dynamics going forward.
Whereas the catalysts of Argentina’s outperformance seem to be a one-off scenario, the rally in Russian bonds has been the result of a combination of factors, including supportive technicals, solid (enough) fundamentals, and very attractive valuations. On the surface, Russia may also seem like an unexpected candidate for outperformance this year: geopolitical risks, significant sanctions and a reliance on oil do not add up to success. However, despite these issues, technical factors have been very supportive, with investors covering short positions, strong support from local buyers, and limited supply. Additionally, some of the less “headline” oriented fundamental factors are actually quite solid in Russia including a strong current account, low debt to GDP, and a deleveraging process underway.
The key question is – will these idiosyncratic, high yield countries continue their outperformance into 2016, or will there be new “lights” among the EM darkness? Or, have valuations become cheap enough across all emerging markets that the entire sector will brighten?