- In assessing how attractive local currency emerging market sovereign debt is currently, we look at four criteria: changes in commodity prices, leeway on monetary and fiscal policy, valuations and external debt vulnerability
- Asian countries appear the least sensitive to falling commodity prices
- With the exception of India, Asia has the most leeway on fiscal policy. In terms of monetary policy Emerging Europe has the biggest margin of manoeuvre.
- Valuations are most attractive in Brazil, but real rates are positive in almost all emerging market debt markets
- The countries least vulnerable in terms of external sovereign debt issuance are in Asia, Russia and Brazil. All of which being well cushioned by large reserves of international currencies
- In conclusion we find that sovereign emerging debt is arguably an attractive investment alternative. Amongst emerging market debt markets we favour India most, followed by China and Poland
Uncertainty is back as illustrated by both ‘fear gauges’, the VIX and the MOVE volatility indices. The main reasons for this are the collapse in oil prices (down by around 60% since June 2014); US hourly earnings unusually lagging payrolls; quite substantial downward revisions by both the World Bank and International Monetary Fund (IMF) in their forecasts for world growth; increasing deflation fears; and far bigger-than-expected quantitative easing (QE) in the Eurozone. To his list one can add the quite widespread geopolitical uncertainty in Eastern Europe, the Middle East and Southern Europe, the latest event of note being the appeal by Greece’s new government’s for an end to austerity. Given all the above elements, a greater diversification of portfolios favouring ‘risk-off’ investments would appear to be a rational inclination.
If we consider the current market environment – where moderately risky return-enhancement opportunities are being chased down because core ’safe-haven’ debt now yields little to nothing – then emerging market sovereign debt re-emerges, in our view, as a rather appealing asset class. The tepid global economic backdrop is likely to limit the aggressiveness with which the US Federal Reserve (the Fed) implements tighter monetary policy, especially as US dollar strength is already tightening financial conditions. And even if the Fed raises benchmark rates, T-bond yields should at worst increase only slightly, since Eurozone QE will certainly lead to a reallocation from core Eurozone fixed income into US T-Bonds.
While being tactically positive on emerging market debt, we do however believe that country selectivity is as important for this asset class, if not more so, than it is for emerging market equities.
As stated above, there are in our view four major factors that we can quantify and use to discriminate between emerging market debt markets. The first three – changes in commodity prices, valuations and the leeway on monetary and fiscal policy (policy mix) – are essentially tactical. The fourth – the vulnerability of external debt funding to an exogenous shock – is a structural, risk-related factor.
One of the principal tactical factors used for discriminating between prospects for sovereign debt of different emerging markets (EM) is commodity prices, more specifically crude oil prices. Oil consuming countries, i.e. net energy importers (see the ranking of net energy importers in chart 1) enjoy an income boost (positive terms-of-trade effect) when oil prices fall, while net exporters (see the ranking of net energy exporters in chart 2) suffer a negative terms-of-trade shock.
How the drop in energy costs impacts growth, inflation, external accounts and public finances depends on whether it is the public or the private sector that benefits or suffers the most from the income windfalls or withdrawals. Elaborating on that would go beyond the scope of this article. The bottom line is that, in the case of net energy importers, lower oil prices mechanically drive down consumer and producer prices, improve external accounts and boost state finances and growth, the contrary being applicable for net exporters of oil. To summarise, based on this factor alone, we would favour the debt of most economies in emerging Asia (EM Asia) and Central Eastern Europe. We would avoid debt issued by sovereigns in West Africa and parts of Latin America (LatAm).
Provided not all windfalls are re-distributed to consumers, those countries benefiting from the drop in commodity prices will experience a welcome increase in their monetary and fiscal margins of manoeuvre.
Leeway on policy mix
Looking at Bloomberg’s forecasts, more than half of the major EM countries will see their fiscal balance improve in 2015 compared to 2014 (chart 3 shows the forecasts), led by Brazil and followed by India, Malaysia, South Africa, Poland, Indonesia and Thailand. However, the first four had deficits in excess of 3% of their GDP in 2014, a level perceived as marking the limit between non-constrained and constrained public finances. Most countries are forecast to experience a deterioration in their fiscal balances post central deficits well beyond the 3% level in 2014.
Certainly, the ’quality’ of public spending has to be considered as well. For example, public infrastructure investments in Indonesia and India, which reduce the impact on fiscal deficits of the fall in oil subsidies, are good for growth and productivity. Similarly, Chinese economic and state finance reforms temporarily weigh on growth and revenues, and thus mechanically add to deficits. But longer term they should prove very positive in economic terms and thus provide additional leeway to China’s policy mix.
Inflation forecasts do not hint at much additional monetary policy leeway in general, since average inflation levels are mostly likely to be higher in 2015 versus 2014. But for many countries, average 2015 inflation will remain (sometimes well) below central bank targets (Chart 4). Also, for some countries the (temporary) spike in inflation is mainly due to ’positive’ measures, as is the case notably for Indonesia, where the government cut fuel subsidies to close to nothing, and to a lesser extent India, for the same reasons.
In terms of valuation, most emerging countries have seen their spreads to 5-year US Treasury bonds tightening over 12 months and since the start of 2013 (see inflation forecasts versus targets in chart 5), i.e. most emerging government bond markets have been experiencing positive returns in local terms over this time frame.
The exceptions are Russia, confronted with sanctions, a falling rouble and oil prices, and Malaysia, which suffered from declining demand for bonds from the Middle East.
India and Indonesia in Asia, Brazil in LatAm and South Africa and Turkey in EMEA post, by far, the highest nominal rates versus their US equivalent.
Looking at real 5 -year real rates, the general picture for emerging markets looks more interesting. In fact, most investable emerging market debt markets are posting higher real yields than before the announcement by Bernanke in May 2013 of a tapering of QE (Chart 6).
Even here there are a few outliers, however. Turkey and Chile, for example, have negative real rates. Both experienced a tremendous rally starting with the Fed’s announcement of the winding-down of its QE programme. Since then, yields have backed up slightly.
Indonesia is posting very low real rates, but this is mostly related to the exceptional jump in inflation following the cut in oil subsidies. Chart 7 shows that with a few exceptions – notably China, which has a de facto US dollar peg – most emerging market currencies look rather undervalued based on BEER and productivity-adjusted PPP models.
Source: Thomson Reuters Datastream, BNPP IP, as of 03/02/2015
External debt vulnerability
The countries most vulnerable to external funding risk, which could materialise with the increase of the Fed funds target rate in the US, are basically those with a) the highest ratio of external debt relative to their GDP; b) the highest ratio of external debt relative to general government debt; c) the highest interest rate payments on their external debt; and d) the lowest international reserves coverage of their debt. Combining these four factors and ranking them shows that with the exception of Indonesia, Asian countries look the least vulnerable on their external debt funding, and should thus be preferred from a pure risk point of view (see chart 8 above).
Greece, Hungary and Poland, which are more indebted in euro terms than in US dollars, are the most vulnerable in relative terms, followed by LatAm countries and Turkey, the bulk of whose external debt is USD-denominated.
Brazil and Russia are not as vulnerable as commonly perceived. Brazil’s share of external public debt to GDP is just 5.5% and this is covered almost three times by their FX reserves. Russia’s ratio of FX reserves to external debt is slightly higher than seven times, a reassuring level. Only China and Taiwan have higher debt coverage ratios than Russia (respectively 43 and 186 times) and their public external debt as a share of GDP is negligible (less than 1% of GDP).
It is worth mentioning that many of the leading emerging countries have reduced their public external debt vulnerability as the table below shows.
In conclusion, local emerging market sovereign debt is arguably an attractive investment alternative. Within emerging markets, we particularly like India, which is flashing green on almost all our selection measures, except the budget deficit. Although Prime Minister Modi’s reform process is moving slower than anticipated, it is likely that growth will continue its ascent towards potential and that public finances will further improve. China’s sovereign debt also offers above average potential in our view. Valuations are less appealing than in India, but China’s margin of manoeuvre in terms of monetary and fiscal policy is much greater. Also, while PPP and BEER models show a slight overvaluation of the renminbi versus the US dollar, we believe the currency risk is reasonably well contained and perhaps even smaller than in many other emerging markets (see also: Up or down? The knowns and unknowns of the RMB “new normal (28/01/2015) by our China Economist Chi Lo). Despite the fact that spreads are already quite tight, Poland looks like another good fixed income play currently. Real rates there are close to 300bp, inflation is close to zero, and fiscal balances are steadily improving. Poland is also one of the main beneficiaries of the ECB’s QE and the zloty appears somewhat undervalued against the US dollar. Admittedly, Poland’s external debt looks highly vulnerable relative to that of other emerging markets according to our score, but not by so much if one takes into account that the bulk of it is denominated in euros, to which the zloty is quasi-pegged.
Two other countries’ local government debt could also qualify for investor’s interest in our view, although the probability of stronger volatility in the short to medium run is far higher than for the markets we have highlighted above. The first is Indonesia. The positives: spreads to the US of 5.5% (above their 5-year average), a net oil importer, a somewhat undervalued currency and a fiscal balance below the 3% threshold. The negatives: a high inflation rate and accordingly low real rates in combination with a higher vulnerability on foreign debt and a FX- reserve coverage ratio of below one. However, as said before, the ‘one-off’ rise in inflation was essentially caused by the massive cut in fuel subsidies, which has many positive structural implications, since it will allow the new reform-minded government to reallocate the budgetary savings towards productive investment, for example ports development and education. This should improve creditworthiness and thus reduce the risk premium on debt (and equities).
The second is Brazil. The positives there are the very high spreads to equivalent US bonds (more than 11%), substantial real rates of about 6%, an undervalued currency versus the US dollar and low vulnerability on external debt, with FX-reserve coverage of around three times. The negatives, however, are very sluggish growth, persistent twin deficits, stubbornly high inflation and the corruption scandal at the state-owned energy company, which is weighing heavily on sentiment. It seems though that the newly-elected government is starting to tackle some of these issues. The finance minister’s austerity programme should lead to a reduction in fiscal deficits and, to a lesser extent, current account deficits, since the economic problem lies on the supply rather than the demand side. Moreover, austerity initially means higher inflation due to the cut in welfare entitlements and the increase in regulated prices and some indirect taxes. The latter is likely to force Brazil’s central bank to increase benchmark rates further. But we believe all these negatives are currently quite well priced in in the debt market. What might not be priced in sufficiently is the fact that the new government’s stance is likely to restore its credibility with financial markets, which should reduce external vulnerabilities and thus reduce the long-term risk premium on government debt. More importantly, it will ultimately free some funds for much-needed investment in productivity-enhancing infrastructure.