Emerging market debt: Back to the future?
By Francesc Balcells, CIO of EM Debt at FIM Partners, an institutional asset manager focused on emerging markets.
The FED and other central banks launch massive asset purchases, equities and global bonds rally, the market piles on inflation hedges, industrial commodities strengthen, and the dollar dips.
Sound familiar? That was 2009-2013, one of the best periods for emerging market (EM) asset prices. During this period, EMs received huge inflows from major bond markets where yields were declining, and external and local EM debt produced 14 per cent annualized returns over four years.
The question of whether “this time is different” inevitably arises. Investors must keep in mind that history never repeats itself exactly, although stock and bond prices look to be at even more elevated levels today. The spread between EM and G10 bonds is almost as wide now as it was in Q1 2009 and today’s market narrative indeed has a similar ring. However, there are some key differences.
Then and now
One clear difference is that the current balance sheet expansion is multiples of that carried out during 2010-13. QE2 and QE3 expanded the FED balance sheet by a bit more than USD2 trillion over four years. However, in the last nine months of 2020 the FED balance sheet is expected to grow by USD5- 6 trillion.
Not only is the current fiscal expansion bigger, it is arguably more aggressive, since money is being put directly into peoples’ pockets to kick-start consumption and stimulate economic demand.
Another key difference is that the real-economy shock from Covid is far more profound and the current economic challenges are less amenable to policy measures. What’s more, the economic changes are potentially more structural in terms of altering people’s behavior than in 2008.
For EM, the differences are notable, too. A big one: China is not playing the leadership role it did after Lehman. Then, the Chinese authorities engineered a massive credit stimulus that percolated through the global economy, giving a lift to commodity prices and a helping hand to many EM countries. This time around, China is playing more of a secondary role, less keen (for now) on broad-based reflation.
The policy response across EM economies has differed as well, being more countercyclical. Fiscal expansion is more aggressive with interest rates cut to record-low levels. Moreover, several countries have even engaged in QE, something that would have been unthinkable just a few years ago.
EM balance sheets, however, are less robust than they were in 2009. Debt ratios are higher and the credit quality of the new issuers which have emerged since 2008 is weaker, with many edging towards distressed status. In much the same way as in the developed world, the EM economic toll from Covid will be far deeper and more disruptive. This time around, the IMF expects GDP in EM and developing economies to contract by 3 per cent, compared with a 3 per cent rise in 2009.
A (smaller) wave
As such, it is worth assessing whether we are in a “2009 moment” since flows into EMs tend to occur in waves and can persist. Indeed, four such waves have unfolded since the early 2000s: inflows during the commodity super cycle; outflows post-Lehman; inflows following the launch of QE in late 2008; and outflows following the 2013 “taper tantrum,” which saw US Treasury yields spike when investors realized the Fed was beginning to wind down QE.
What made the 2009-13 wave exceptional was the huge scale of the flows to EM local markets. Foreign investors went from practically no exposure to a sizeable weighting. Take Mexico, for example, where foreign holdings of peso-denominated Bonos went from 20 per cent of the market in 2010 to almost 70 per cent in just four years. Similar shifts happened in many other EM countries.
Since 2013, however, portfolio flows into EM have slowed and even reversed. Other type of flows, such as bank credit , mostly syndicated loans and trade finance, turned heavily negative as global banks retrenched since the great financial crisis. Accordingly, FX reserves have stagnated since 2013.
Given this backdrop, the next capital wave into EM is unlikely to be as pronounced, given existing local market exposures, unless there is a marked shift in the behavior by global banks or new sources of demand for capital emerge. Among the latter, sovereign issuers from the Gulf, the Chinese fixed income market, and some local markets in the frontier space will become increasingly even more important than they are today.
Capturing the flow
Market participants will therefore be wondering how best to capture a potential uptick while navigating a deterioration in EM growth prospects, given the relative attractiveness of EM as G10 yields tighten.
Savvy investors should therefore focus on an asset class that provides ample yield but is protected against a weakening growth outlook. External debt fits this brief, given that it is anchored to balance sheets and is less sensitive to economic growth.
Tactical allocations to EM debt offer a prudent approach. Observations of country risk on a case-by-case basis can help to ensure favorable convexity in position taking – something that active managers with EM expertise are set up to do in a complicated EM debt environment.