Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Claudia Calich, manager of the M&G Emerging Markets Bond Fund, discusses where she sees current opportunities and risks in the asset class.
Emerging bond markets have delivered decent returns in the year-to-date period, despite fluctuations along the way, thanks largely to a solid rally during March and April. While gains were registered across the sovereign and corporate sub-asset classes, it was local currency-denominated government debt that has led the performance rankings in a marked reversal of relative performance compared to last year.
Looking ahead in 2016, returns are likely to consolidate at a slower pace than those seen year to date. Importantly, however, with the asset class providing yields in the range of 6-7% on average, even if the price return slows going forward, there is still the attractive prospect of the carry return.
Within the macro outlook, some of the larger developing economies should finally start bottoming out in terms of growth. The IMF recently released its updated World Economic Outlook and, for the first time in a long while, it has not materially lowered its forecasts for emerging market growth.
Winners and Losers
Against some of the ongoing key challenges in the asset class, there will be winners and losers among emerging market bond issuers. For example, oil prices remain significantly below their levels of over 18 months ago, despite firming up so far this year. While oil exporters lose from cheaper prices, oil importers may gain from such lower costs. As a result, value can be found among both government and corporate issuers in oil- and commodity-importing countries, with examples in Asia that include India and Indonesia, as well as eastern Europe on a selective basis.
Also in Eastern Europe, some markets should benefit indirectly from the European Central Bank’s (ECB) expansion of economic stimulus measures, which have included further cuts in interest rates. The ECB’s policies have pushed yields lower or further in to negative territory in the euro area, which in turn has helped these neighbouring markets become more appealing. Government bonds in Romania provide an example, based on their higher yields relative to government bonds from other eastern European countries, as well as compared to developed European markets.
In Latin America, Argentina’s recent return to the sovereign new issues market can be viewed as a positive development on several counts. Relevantly, the move helps to normalise the country’s financial relations with international markets and should also help to increase its foreign exchange reserves, which had fallen worryingly after being excluded from markets for some years. Overall, Argentina seems on course to deliver positive reform momentum, managing its economy with more orthodox policies and continuing to improve its relations with the West.
Among other larger markets in the region, Mexico’s sustained fiscal deficit and cheaper oil prices are adversely affecting its economy, while Moody’s recently downgraded its outlook on the country. On the other hand, however, lower oil prices led to a depreciation of the peso that is positive for export-oriented Mexican companies, some of which particularly benefit from the relative strength of the US economy.
In Brazil, the replacement of President Dilma Rousseff by Michel Temer has been well received by investors and Temer’s economic policy agenda is promising. It should also be underlined, however, that his team still has important challenges ahead with regards political support and governability. In terms of timing, Temer potentially benefits from the prospect that Brazil’s economy could bottom out in the second half of the year. Also, the current account adjustment continues and foreign direct investment has remained robust despite the political uncertainty.
Among other factors, inflation has started to decline, which should also help the macro environment and may allow the central bank to start cutting rates later this year. In the short term, therefore, Temer has a few tailwinds going for him. In the long term, however, for this backdrop to have a long-lasting impact in the economy, it is important to see how much support he will have from Congress. Congress will need to approve key reforms, particularly measures to reduce the country’s high fiscal deficit.
Elsewhere, opportunities can be found in select smaller markets in Central America and the Caribbean that have strong ties to the US economy. Relevantly, for example, certain countries should gain from increased remittances from their citizens based in the US who are employed in its robust labour market. Partly based on these considerations, sovereign bonds in Honduras, Guatemala and the Dominican Republic, look attractive.
Cyclical Recoveries
In terms of the broader outlook, emerging market debt is an asset class that has faced challenges on the past years, mainly including falling growth, weak commodity prices, political uncertainty in some countries, and rising corporate defaults. However, the rate of credit deterioration should start slowing as commodity prices – particularly for oil – seem to have stabilised and economic activity in some key countries that have been in recession should start stabilising later this year. In addition to Brazil, Russia is a potential example.
This cyclical recovery should start helping to slow the pace of deteriorating debt dynamics and credit quality in some of these key countries. The question is not if the asset class is improving in quality, which it is not, but are you getting paid for owning it if the pace of deteriorating is slowing? The answer is yes, particularly in light of the search for yield given low or negative yields in a large part of the global bond markets. The risks need to be managed carefully at this point of the cycle – with the avoidance of the worst-performing issuers and/or defaulters being critical – but provided that is done properly, there are opportunities to be found in the asset class.
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