While the late May sunshine washed the back row of Mr. Coates’ class, the great man strode to the blackboard with a decided case of the furies. It was 1983, and the US was in the middle of an economic expansion that was controversial in Massachusetts. Like it or not, we kids were about to get schooled. “Today we are not going to talk about geometry” he intoned, his Boston accent a thick gravel of bourbon and smoke. “Instead, we’re going to talk about cyclicality.”
Unfazed by the sounds of desks being moved to catch the sun in the back row behind him, Mr. Coates proceeded to draw an enormous sine curve on the blackboard, and then pointed towards the top, announcing “we are here.” With a wicked grin he then pointed at the bottom and announced “we are going there.” This, he claimed, was a feature, before adding that some things become more or less probable depending on the cycle. “Hula hoops come into fashion every 7 years…” Mr. Coates paused, triggering a groan from the back row, “and this year is not their year.”
So here we are on an unseasonably warm and sunny February day, and I wonder if this might be the year of the emerging market hula hoop. Could 2019 prove to be the year that emerging markets’ resilience finally wins it larger allocations? Will we finally see the asset class’ perpetual promise reflect in a broadening sponsorship?
Certainly, the flow of funds picture in emerging markets is flagging that something interesting is happening. The seven weeks of inflows that we have seen this year suggest an increasing acceptance of the asset class by fund selectors and investors alike. That might seem odd after a year like 2018, which doesn’t read like a triumph: a year of outflows, country specific macro events, and volatility that even saw the temporary disappearance of the Turkish forward market. These events reflected in asset allocations, with global portfolio exposure to Emerging Markets Debt entering 2018 at a near historic high of 13%, and finishing it at around 10%. That closing level is crucial, because it means that asset allocators responded to events by top slicing risk rather than divesting. In the past, noisier emerging markets performance has sometimes contributed to allocators more sharply reducing weights. That the combination of a Fed policy signal change combined with Chinese stimulus efforts has been enough to trigger inflows reflects asset allocator’s growing confidence in both the opportunity and the asset class.
What’s changing here isn’t the promised return, which may be a little lower than what has been on offer in previous bullish years. Instead, it is the risk around that return, and allocators’ understanding of it, that has contributed to shift positioning. While 2018 was a challenging year in EM, it wasn’t so bad that it caused panic. When compared with previous emerging market drawdowns or consolidations, it appeared almost orderly in character. Because the resulting downturn wasn’t enough to really scare fund buyers, they’ve returned to the space more quickly, snapping up the Emerging Market Hard Currency sovereigns yielding 6.8% in December, while adding Hard Currency emerging market corporates yielding 6.3%.
But what is most notable about last year is what didn’t happen. While the market debated rising risks, cyclical position and slowdown, emerging market issuers mostly carried on servicing. In the EM credit space, consensus looked for higher default rates in 2019; to date, that hasn’t happened, as most EM corporate issuers have carried on paying coupons. Having pushed out debt maturities, corporates’ margins have remained resilient and the number of default candidates remains broadly unchanged sequentially. In 2018, EM corporates gave us double digit revenue growth – and the strongest EBITDA growth we’ve seen since 2011. In response, spread implied default rates have steadily tightened since the New Year, and now sit around 1.9%, comfortably lower than current sell side default estimates of 2.6%. Some of last year’s higher profile fears of impairment have not materialized at all: for example, Turkish banks continue to service in defiance of 2018 expectations. The short end of the Turkish banks curve today offers yields in the low 6% range, a far cry from distressed levels. Simply put, this doesn’t sound like a crises.
If you still don’t think this move is anything unusual, consider this: even an intensification in events in Venezuela, culminating in US sanctions that froze the market in the country’s hard currency bonds, was not enough to stop the inflows. While Venezuela has been well flagged as a possible default case, both it and local oil company PDVSA remain reasonably well owned across the emerging markets community. Not so long ago, a whiff of populism or a good riot in the town square anywhere in EM was enough to worry the market and elevate spreads. Apparently not now: in the month of February alone, over a million Venezuelans took to the streets of Caracas to protest against their leadership, the US imposed heavy sanctions, ratcheted up political pressure and recognized an alternative government. Rather than pack their bags, wholesale investors instead responded with a $3.95 billion dollar inflow into EMD for the month (so far). In the last week of January, mutual fund and ETF investors injected $3.03 billion, a record setting performance that crushed the previous high set in 2016.
Such developments make uncomfortable reading for asset allocators sitting on reduced positions. Many investors ended 2018 decidedly unsure about what to do with the space, and they’ve clearly spent some time cross examining that position. Yet we find risk budgets remain tight and allocations light in many places. With macro policy shifting to a more supportive stance around the world, that view might get painful. There are hints of more to come: Hope of a trade deal with Washington has reversed non FDI capital outflows from China, for example. When the White House announced a delay to the 1 March trade deadline, markets around the world rallied in response.
This isn’t to say that emerging markets isn’t somehow risk free. The 2019 electoral calendar is a busy one, while several countries face difficult choices over the management of external debt. Should trade negotiations with China disappoint the market, the results could be negative for the space. The mature world acts as a demand driver for the emerging one, meaning that a sharper cyclical slowdown would also have a negative impact on returns. 2019 will have its testing moments, we think.
But back to the hula hoop: if emerging market issuer fundamentals remain steady, then both the 5.5% corporate yield and 6.2% sovereign yield should be enough to entice further inflows. Given a relative lack of new issuance, the effect of allocators topping up may give our asset class a healthy push. If we get our hula hoop year, the steady improvement in emerging market fundamentals will continue to reinforce in selectors the idea that the class can deliver quality returns, potentially increasing the size of allocations.
So will 2019 prove to be the breakthrough year that sees emerging markets deliver on its promise while widening its sponsorship? It certainly feels like another step on that path.