Every October, EM debt investors flock to Washington D.C. to attend the IMF Annual Meetings. Since the same event last year, we’ve seen significant shifts in the backdrop for EM debt. The Fed hiked 75 bps, US Treasury 10-year yields rose about 50 bps, and commodity prices (CRB) dipped around 2.5%. Notably, the much awaited (and often feared) Fed QE tapering finally started. Advanced knowledge of these outcomes may have brought fear to participants a year ago. Instead, investor sentiment at this year’s gathering was decidedly positive and expectations for EM debt in 2018 are upbeat. While this in part reflects strong EM debt performance YTD, more forward looking elements are at play as well.
One such element is the now more visible global growth upswing. The IMF now sees global growth reaching 3.5% and 3.6% in 2017 and 2018, respectively, each up 0.1 p.p. from its previous forecast. This marks a second sequential global growth upgrade, in contrast to the Fund’s pattern of downward forecast revisions in recent years. China’s better than expected growth in 1H17, and expectation that growth ahead may soften only moderately, further bolsters sentiment regarding EM in this context. Qualitatively, the synchronized nature of DM and EM growth recoveries also points to positive feedback loops through trade and capex that may benefit many EM economies, and ultimately add to the upswing’s sustainability.
A second equally, if not more, important element is a widespread sense that the upswing will not be constrained by rising global inflation, or at least not for a while. Presentations at the meetings attributed persistently low global inflation to competing factors, including residual global slack, the demise of the Phillips Curve and/or the “Amazon Effect”. While the debate is far from settled, the consensus is that any inflation rebound ahead looks set to be shallow due to some combination of the cited factors. Notably, this conclusion seems broadly shared by policymakers attending the meetings.
For EM debt, this global macro configuration, if it holds, would preserve the core of the “Goldilocks” backdrop that allowed strong returns over the last year. Benign inflation dynamics would still allow a gradual reflation environment where G3 Central Banks’ unorthodox policy exits continue in a mostly orderly and well communicated fashion. Gradually rising core yields in this setting, amid sustained global growth, would still be supportive of capital flows into higher yielding EM debt.
With this consensus view, it is not surprising that those attending the meetings no longer identify rising G3 policy rates and/or QE Tapering as the leading risk for EM bonds presently. China’s debt overhang, in turn, is often cited as a leading EM specific risk, but one considered more relevant only over the medium run. Instead, investors’ current concern is focused on potential political and policy shocks. In particular, US trade and security policies are seen as a particularly unpredictable risk presently. The risk of NAFTA termination and/or new sanctions in connection with North Korea are not only a focus regarding potential direct impact on Mexico and China, but indirectly on EM broadly if it escalates into trade wars.
Pending more clarity on this, political and policy risks look set to drive risk premia within EM debt as well during the next year. In the twelve months following this year’s IMF meetings, 22 EMs are scheduled to either hold Presidential or Parliamentary elections, or key political transition events. This group accounts for close to 2/3 of EM GDP and 33% and 40% of hard and local currency debt index benchmarks (i.e. EMBIG, GBIEM), respectively. Some of these events seem fairly predictable (e.g. China’s 19th Party Congress), but many others entail significant binary prospects for those credits (e.g. Argentina’s congressional elections this week, Brazil and Mexico’s Presidential elections in 2018), hinting at potential asset price volatility around these events and tactical opportunities for EM debt investors.
So the clear message from the IMF Meetings is that, even amid wider ownership and tighter valuations, EM debt is still favored by investors looking for the interaction between synchronized global growth and gradualist G3 policy normalization, supporting the asset class into 2018. However, investor attention is increasingly shifting to event risks, including political and policy risks in DM and EM that will need to be navigated carefully. Hence, another key message from D.C. is that while the last year was more about Beta and passive exposure, the year ahead seems more likely to be about Alpha and active management for EM debt.