Regular readers of our Emerging Market (EM) Debt Strategy Quarterly will have noticed that we have been advocating the case for active beta management since late 2016. Whilst a superficial look at EM bond market returns would seem to suggest that investors continue to prefer beta strategies, we believe that there is growing evidence of a change in investor positioning.
The reasons for advocating this shift are by no means trivial. In fact, there are good arguments for staying long beta, perhaps most importantly the ongoing improvement of emerging market fundamentals. Most EM investors will be familiar with the typically quoted macroeconomic statistics such as increasing GDP growth, stable or improving current account balances, and decreasing fiscal deficits and inflation. In addition, better macro numbers are increasingly translating into improving bottom-up statistics such as upgrade / downgrade ratios, corporate leverage and earnings expectations. Furthermore, they lead to more favourable market technicals. For instance, smaller fiscal and current account deficits typically mean lower re-financing requirements for governments and corporates and consequently, less bond issuance. In sum, there are robust fundamental and technical reasons behind the on-going EM bond market rally since February 2016.
So why should investors care about active beta management at all? First, EM bond valuations are looking increasingly expensive with few exceptions. Our EM vs. DM valuation scoreboard (using 5-year Z scores) shows that EM FX vs. USD remains cheap and EMBIG HY vs. US HY and EM Rate marginally cheap; whilst all other sectors are either marginally or very expensive. So in contrast to fundamentals and technicals, valuations offer a much less attractive investment case for EM debt.
Second, we continue to see various risks that could adversely impact emerging markets debt. Perhaps the most important risk is US growth and the Fed’s monetary policy. In view of the ongoing economic recovery in the US, coupled with potential tax reductions, we believe the market consensus may be too complacent by pricing in only one interest rate hike in the remainder of 2017. The other major risk is politics. The market has taken the outcome of the constitutional referendum in Turkey in its stride, but the upcoming presidential election in France in April and May and general elections in Germany in September could potentially negatively affect appetite for EM debt. In short, taking into account these risks and the relatively expensive valuations of EM debt, the case for simple beta strategies appears much less attractive.
However, can we observe early signs of a shift in investor sentiment? Whilst fund flows tend to be a concurrent indicator, we nevertheless believe that they offer a meaningful guidance to investor sentiment. The chart below shows all flows to dedicated EM debt funds and ETFs since the beginning of 2016, as calculated by the GFICC Quantitative Research team. Not surprisingly, ETFs have been capturing the bulk of flows in the past 15 months. In fact, ETF flows turned positive in March 2016 and have been dominating overall EMD flows since then.
That being said, we have been observing two periods of open-ended funds capturing market share from ETFs. The first was in September-October 2016, ahead of the US presidential election, and more recently in 2017. Indeed, the latter started before the March rate hike by the Fed and has continued since then. And in both instances it could be argued that investors were preparing for potential risk events.
The breakdown by sub-asset class shows significant differences between the various strategies. The picture for EM sovereign strategies more or less mirrors the aggregate, which is not surprising given that this strategy dominates the market for dedicated EMD ETFs. EM sovereign ETFs have been attracting the biggest inflows of all EMD strategies, but open-ended funds have been gradually gaining market share since late December 2016.
The picture for EM local currency strategies is more dramatic, given that ETFs captured more or less all inflows since 2016 while open-ended funds continued to suffer outflows. Corporate strategies show the almost opposite picture, with almost all flows being captured by open-ended funds and ETFs only a relatively small amount.
We would refrain from reading too much into this as flows to local currency and corporate open-ended funds and ETFs are more driven by strategy-specific factors than beta vs. alpha considerations. Nevertheless, we can observe renewed demand for actively managed open-ended funds since the beginning of this year, which lends support to our view that investors are increasingly looking for active beta management.
We also looked at average market betas for any signs of a shift in investor sentiment. Similar to fund flows, average market betas should be taken with a note of caution as they are concurrent indicators. Nevertheless, significant changes in market betas can provide a meaningful indication of investor sentiment.
The chart below shows average betas for the three main EMD market indices. All three are lower than in December last year and two have further decreased since February 2017. The average beta for EM corporate (CEMBI) appears to have taken the biggest decrease, falling to its lowest level in the last two years, whilst EM local currency debt (GBI-EM) has fallen close to the recent lows in mid-2016. EM sovereign (EMBIG) has actually seen the biggest fluctuation, decreasing sharply in January-February but climbing to year-to-date highs in April.
Perhaps most interestingly, EMBIG and CEMBI betas seem to have become de-synchronized and whilst that might not necessarily suggest a major shift towards alpha strategies, it still signals that investors differentiate more between the various EMD sectors than in 2016.
Whilst dedicated EMD strategies have continued to attract inflows since February 2016, actively managed open-ended funds have been able to gain a growing share of these flows since the beginning of this year. At the same time, average market betas of dedicated EMD are lower than in 2016, which means that on balance, investors have increased allocations to EMD whilst trimming traditional market beta exposure. The outlook for EM debt remains supported by improving fundamentals and robust technicals, but expensive valuations and latent developed market risks further strengthen the case for active beta management.
Political events over the last two weeks have earned South Africa the distinction of having had four finance ministers over a fifteen month period. Last month’s decision by President Jacob Zuma to reshuffle the cabinet and replace the finance minister, Mr. Pravin Gordhan, and his deputy marked the culmination of a long power-struggle between the president and the finance ministry over control of state resources. The fall-out from that decision was immediate with significant pressure on South African assets. More importantly, S&P downgraded South Africa’s sovereign debt one notch to sub-investment grade and kept a negative outlook citing increasing fiscal risks and policy paralysis due to political splits within the government. Both Moody’s and Fitch issued statements outlining similar concerns with Moody’s going a step further, putting the sovereign on review for a downgrade.
There are a number of reasons for this latest move by the presidency but the most immediate is Mr. Zuma’s quest to ensure an African National Congress (ANC) win spearheaded by his preferred candidate in the 2019 general elections. In recent years, the ANC party has lost some support amongst its constituents. This was apparent in last year’s local elections where the ANC lost its majority in several key states. As a result, there has been a shift in the party’s focus with inclusive social transformation taking a more prominent role amongst Mr. Zuma’s supporters at the cost of fiscal discipline. What form this social transformation takes is not clearly articulated but what is clear is that in this new world, there is little room for a fiscally conservative finance minister. Therefore the decision to replace Mr. Gordhan, who had won back fiscal credibility for the nation over his short tenure, with a relatively unknown candidate raises uncertainty around the future economic and financial policies of the government.
Prior to this, there had been some improvements in the macro data in recent months as the country’s terms of trade benefitted from a weaker currency and rising commodity prices. Inflation also appeared to be moderating due to lower food prices and a stable currency. As a result, there was a building expectation that the central bank would commence a rate cutting cycle given relatively subdued growth. This coupled with shifting momentum on the macro-economic front had seen an increase in foreign investments into the local bond markets.
With last week’s events, political uncertainty is likely to overshadow an improving macro picture and could see further underperformance of South Africa’s assets as the ratings cycle turns more negative. This in turn will push back the rate cutting cycle and could prompt rate hikes should the currency move become disorderly; a high risk should we see a reversal of flows materialise. Moody’s and Fitch are likely to follow S&P in downgrading South Africa in the coming months, resulting in a loss of South Africa’s dollar debt’s eligibility in investment grade only indices. While experience from other emerging markets has proven that to be a good buying opportunity, the removal of the ratings downgrade overhang will only serve to remove any incentive from the administration to adhere to fiscal targets. Signs of a strong and credible opposition to the current president or adherence to fiscal consolidation and economic reform could turn the tide for sentiment. Although it’s early days for the new finance minister, changes in the national treasury stance on key topics (e.g. nuclear energy) that would have an adverse impact on the budget suggest this is unlikely to be the case and suggests there are further headwinds yet to materialise for South African assets.