18 Jun 2018
Emerging market bonds have fallen sharply in recent weeks, with debt denominated in ‘local’ currencies bearing the brunt of the sell-off, as exchange rates plumbed 2018 lows. That marks a sea change in sentiment from earlier in the year.
The catalyst for this shift in attitudes was the US dollar, which began rising sharply in mid April after US Treasury yields climbed above three per cent. Faced with near record-low interest rates in many developed economies, international investors had been only too willing to lap up high levels of debt issued by emerging nations and their corporations. Suddenly the rationale for that strategy is under the spotlight.
Argentina and Turkey have taken centre stage, with both nations’ currencies having tumbled to record lows, as investors pull money from two countries which they see as being heavily reliant on foreign inflows of capital.
In this Q&A, Aaron Grehan, deputy head of emerging market debt at Aviva Investors, gives his perspective on recent events, where the markets go from here and the risk of contagion.
Low interest rates in developed economies have encouraged investors to seek higher returns elsewhere. Much of this money has flowed into emerging markets, which have delivered strong returns for investors. However, with US interest rates having been rising steadily for some months now, investors have suddenly become nervous and are reappraising the ‘external’ risks facing some countries.
With inflation – a perennial problem for Argentina – running at 25 per cent in 2017, and the country running large budget and current account deficits, its currency and debt have been obvious targets. Investors have been selling both. Argentina’s problems are magnified since it remains reliant on foreign capital to fund its deficits.
The central bank recently responded by hiking interest rates to 40 per cent to protect the currency. Such high rates of interest are only viable in the short term, since they would destroy the economy. Reports suggest Argentina is seeking a $30 billion credit line from the International Monetary Fund (IMF) in an attempt to calm the situation and prevent the kind of full-blown crisis that has plagued the country in the past. The hope is that this will enable the central bank to lower interest rates, thereby preventing major damage to the economy.
In Argentina’s case there are some grounds for cautious optimism. The peso has fallen by around 18 per cent while debt markets are sharply lower too. We believe the selling pressure should start to abate given the action taken by the government and the potential for an IMF deal.
However, the domestic political situation suddenly looks more worrying. Over the past two and a half years, the government of Mauricio Macri has taken some big steps towards winning back market confidence by instigating widespread economic reforms. The question now is will his popularity suffer as a result of the decision to go cap in hand to the IMF, particularly if the institution demands a big fiscal tightening as a precondition of its assistance.
Inevitably in the current environment investors are seeking out the next weakest link in the chain, and Turkey has become a focus. It is also battling rampant inflation, which is currently running at 11 per cent, more than twice the central bank’s target. On top of this, there are worries as to whether the country will be able to continue funding its persistent current account deficit as it relies on foreign portfolio flows to do so.
However, while emerging markets as a whole have been under pressure, the sell-off has been far from indiscriminate. Investors appear to have become more discerning by focusing upon each country’s fundamentals. For example, Colombian local currency debt has returned an impressive 8.46 per cent year to date. There is a very strong argument to say that rising US bond yields have removed some froth from the market, which is a welcome development.
While the global macroeconomic backdrop has provided markets with some challenges lately, we believe it remains supportive overall. In most emerging economies, growth is strengthening and inflation is under control. At the same time, monetary policy remains extremely loose around the world. Even in those countries where it is being tightened, such as the United States, that process will remain gradual.
While recognizing the risks of investing in emerging market debt appear higher than at the start of the year, given the sell off we believe investors are being adequately compensated for those risks.
Having said that, we are cautious of investing in debt denominated in ‘hard’ currencies given the risk US interest rates rise faster than currently anticipated. Should that put pressure on emerging market currencies, it could impact the ability of some countries to access markets to refinance their debt.
Aside from Turkey and Argentina, this year’s elections in Mexico and Brazil have the potential to upset markets, while there is the potential for Russia to be hit with further sanctions. It seems investors will be on the lookout for sources of risk more than in 2017, so the dispersion of returns between markets is likely to be much greater.
It is clear there has been a significant change in sentiment from the market being very bullish at the start of the year to being more neutral now. Liquidity conditions and the rapid change in sentiment make for a shaky backdrop and further negative returns run the risk of generating further outflows of capital.
In view of this, we have made a number of adjustments in recent weeks. We have reduced exposure to Russian debt given the country’s deteriorating relationship with the West could lead to further sanctions, damaging the economy. We have also removed any exposure in the funds to the Brazilian real.
At the same time, we believe emerging market currencies are cheap. The recent rise in yields has created opportunities to invest in selective local currency debt markets – in particular in Peru and Indonesia – at attractive levels and we are looking to increase exposure to these markets.
Aside from this, our preference is for mid- to high-yielding markets we believe have more defensive characteristics, such as Ukraine, Paraguay, Angola and Qatar.