Emerging Market sovereign and corporate bond yields have risen steadily over the course of the year, with yields lifting visibly since the late summer. With sovereign yields now sitting at 7%, we have arrived at levels not seen since 2009. Is this an opportunity?
To begin, we first have to understand what is “in the price” and then decide how we think that may evolve from here (“what’s next?”). Investors’ apparent lack of confidence in emerging markets reflects in the asset class discounting a more negative world view versus that seen elsewhere. An analysis of emerging markets across sovereign and credit suggests that investors are looking for between 65 and 75 basis points of rate increases – a view that is more pessimistic than both our house view and that of the GS US Financial Conditions Index. Investors also appear pretty bearish towards China – and some of those countries that supply it. That feels excessively negative to us.
In China’s case, investors may be misunderstanding the depth and resilience of the second largest economy. Chinese policymakers had spent the last couple of quarters guiding the world’s second largest economy towards a soft landing, before Washington moved to curtail Chinese access to the US economy through tariff barriers and a revised NAFTA agreement. The move worried investors, who began to reduce growth expectations and holdings in response. In recent years, the main drivers of Chinese growth have been investment and consumption, which leaves Chinese policymakers well positioned (and equipped) to respond to the slowdown. Worth noting is the scale of the numbers involved: while US trade with China is around $680 billion annually, Chinese GDP prints in the region of $12 trillion. Meanwhile, it is notable that weakness in the Chinese currency has not resulted in substantial outflows from the country, even as CNY tested the 7.00 level against the dollar. We have revised our expectations downward in line with events. Should Chinese growth surprise even slightly to the upside of reduced expectations, the effect on emerging markets bond prices would be positive.
Meanwhile, Emerging market corporates have been adjusting their balance sheets for the reality of rising rates for some time. We’ve seen an active yield to call theme in the EM corporate space, which reflects issuers seeking to recycle and push out maturities. Emerging market corporates continue to offer investors access to 30% gross margins, 6 years of interest cover, and less operating leverage than US peers. A crucial distinction between emerging market and developed market credit informs this trend: far fewer emerging market corporate issuers are public companies, with family groups retaining control of many issuers. While public companies can make better creditors, family groups’ interests can align with investors due to reputational and cost of capital issues.
Another source of support for emerging markets might come from an unexpected direction. Two years ago, we saw substantial inflows into short duration credit strategies that offered investors a tool for reducing overall portfolio duration – without impacting income or elevating expense ratios. These strategies addressed a critical need for global portfolio managers, making the emerging market element of their composition essential incidental. In 2019, investors might seek protection from both a weakening dollar and rising interest rates, and in the process seek a high yielding, liquid, and investment grade asset class with negative dollar sensitivity. Such a thing does exist: It’s called emerging market local currency, and the space is beginning to see inflows.
We do not believe that emerging markets stand at a crossroads. While the lower mature market yields which resulted from QE may have made emerging markets’ higher income potential more attractive at the margin, they were not exclusively responsible for the development of the asset class over the last decade. However, we do think that the character of the opportunity has shifted from being beta driven towards a more alpha focused paradigm, a shift in market character which may advantage more flexible investment strategies.
Since 1994, emerging markets have rewarded investors that have bought into the asset class’ periodic weakness. The market may be entering a period where it offers attractive value. More positive Chinese growth numbers, or even evidence of the Fed stepping back from a pace of interest rate rises might be sufficient to deliver a rally in emerging markets bond returns. While emerging markets have at times presented more volatile performances than peer asset classes, the reality is that the space has delivered a competitive returns trajectory over the long term – and as a result, drawdowns have sometimes offered appealing entry points.
Like a food connoisseur at a restaurant, Asian bond investors have an extensive menu of options to refresh their investment “palates.” They can opt to invest across the fixed income spectrum from hard or local currency sovereign bonds to corporate credit and the forex market.
However, on closer inspection, the extensive menu masks what has been pretty bland and unappealing fare in 2018, as a function of the challenging period these markets have faced.
The Asia dollar bond market has been in turmoil, heightened geopolitics and trade tensions sapped sentiment, fears of contagion skittered across markets, defaults have punctuated the China domestic corporate bond landscape and emerging market (EM) currencies have generally slid against an ascendant U.S. dollar. Indeed, “quiet dining” has become a luxury.
But come 2019, there are reasons to believe the menu is starting to look tastier. Meaningful pockets of value are now emerging – particularly in EM Asian currencies, which are now looking temptingly cheap.
Main course: fear is easy, greed is hard
So far, 2018 has been a year in which risk aversion and defensive positioning have been the optimal strategies to protect against downside risk. But now maybe the time for investors to dip their toes back into these markets selectively.
Although a difficult task, investors should think counter-cyclically. For example, the outlook for continued U.S. interest rate hikes and quantitative tightening has already pushed up bond yields, which move inversely with prices. Rising yields equate to capital losses on bonds, but also translate into more attractive future income generation. As such, higher yields generally improve the return buffers towards fixed income and is applicable across government, credit and local currency bonds.
For example, if an investor were to purchase a corporate bond that yields 5.0% with a duration of three years, the yield on that bond could increase by as much as 1.6% before the bond’s total return would be eroded to zero for the whole year. If the investor is confident in the bond’s credit quality and does not believe it will default, the yield levels provide a decent buffer for the investment, even if we see a further 0.5% to 1% in U.S. interest rate increases.
À la carte: Chinese government bonds – the counterintuitive trade war hedge
Surprisingly, Chinese government bonds (rates) have performed well this year, undeterred by heightened trade tensions and the anxiety over the falling renminbi. Indeed, mainland China’s bonds outperformed other Asian currency sovereign debt in the first six months of 2018 as domestic investors sought safety amid turmoil in stocks.
With the tailwind of structurally greater foreign participation in the mainland China bond markets and the backdrop of accommodative monetary policy, long-term fundamentals look supportive for China rates, providing investors with a diversified income stream. And with currency hedging costs still relatively moderate, investors have the ability to engage in rates exposure for capital gain potential and carry while mitigating forex risk.
Current Chinese policy moves to provide fiscal and monetary support to protect economic growth and negate the negative impact of trade tensions suggest the outlook may be marginally brighter for credit – any pause in the ongoing deleveraging campaign may contribute to easier credit conditions.
Dessert: escalating trade tensions may not be all bad
Looming tariff exchanges between China and U.S. have the potential to further impact investors come 2019. Already, one of the impacts is supply chain diversification, as manufacturers consider potential relocations to continue to serve clients and reposition their businesses. That may turn out to be a plus for some Asian economies, which have also undergone a re-pricing alongside the rest of the EM complex.
Anecdotal evidence suggests manufacturing relocation could impact a broad range of industries from textiles and semiconductors to pet-food. Although net losses for China and the U.S., such moves could have positive implications for Southeast Asian economies, who are the likely beneficiaries. For fixed income investors, this suggests interesting bond investment and local currency opportunities emerging in ASEAN.
Although the market’s volatile cycle in 2018 has led to indigestion for some investors, it is important to acknowledge that as market conditions became gradually more negative through the year, valuations have commensurately improved to reflect the growth downgrades.
In particular, Asian bond valuations have improved significantly relative to 2017, meaning investors are rewarded comparatively more to take on risk precisely because the markets expect more volatility down the road. Periods of market weakness can be opportunities to add measured risk to portfolios. In the face of continued negativity, investors should be prepared to capitalize selectively on the more attractive yield buffers.
In what is increasingly a buyers’ market, those who take a disciplined approach in the search for asymmetric gains in the market may be rewarded over time. We are increasingly looking for opportunities to add back risk selectively in higher yielding instruments which are mis-priced relative to their fundamentals.
In other words, pick your investment palate wisely, look for good value and mull over every mouthful as being mindful has its benefits.