Emerging Markets Bonds and Currencies in an Uncertain World
By Ignacio Sosa
December 9, 2011
As the turmoil in Europe intensifies amid sharp market volatility and policymakers’ continued wrangling, all global risk assets, including emerging markets (EM) investments, are likely to feel the effects. That said, even if the global risk environment deteriorates significantly, our baseline secular view sees EM economies likely to continue along a trajectory of stronger relative growth. Within EM, select external sovereign debt, corporates and currencies may be better positioned to withstand a global downturn (though not without periods of heightened volatility), while some regions, especially those with close economic ties to Europe, may be more exposed to downside risks.
Secular Outlook: Multi-Speed World with Emerging Markets Setting the Pace
Over the secular horizon, we expect EM countries, quasi-sovereigns and many corporates will likely continue to have significantly better balance sheets and economic growth prospects than their developed market (DM) counterparts. Many global investors are redefining the very meaning of sovereign risk and are increasingly concerned about their significant exposure to both DM sovereign bonds and G-3 currencies (euro, U.S. dollar and Japanese yen). For these investors, EM may continue to offer an attractive diversification alternative with compelling risk-adjusted return characteristics. A deeper, more systemic crisis in the eurozone would likely not change the secular trend toward increased allocations to EM fixed income and currencies. We believe the key for investors is to remain focused on the strong EM secular story while understanding that the road to attractive risk-adjusted return potential in the sector will almost certainly be bumpy.
The positive secular outlook for EM is counterbalanced by an increasingly weak cyclical outlook for DM in general and for the eurozone in particular. The weakened outlook for DM is likely to translate to bouts of significant global risk reduction. EM assets remain a risk asset class and will not be immune to waves of global jitters.
It’s also unclear whether we will get a cathartic event in Europe that will signal a bottom – a turning point in the crisis – in the same way that EM defaults in earlier crises signaled lows in EM asset prices. The good news is that unlike the sudden shock of the Lehman bankruptcy in September 2008 and the rapid subsequent deterioration into a systemic credit crunch, global investors have had well over a year to reduce leverage and risk during the ongoing European crisis. Also, a technical factor that differentiates EM foreign exchange rates and credits today vs. late 2008 is that the Lehman bankruptcy happened at a time when leveraged investors such as hedge funds and banks accounted for 50% of the EM investor base – as of October 2011, this figure has been cut roughly in half. Macro tail risk hedging is also likely more prevalent than in 2008.
The bad news is that a systemic sovereign crisis in the eurozone is as unprecedented as it is significant and comes on the heels of a global financial system still dealing with the aftermath of 2008 and 2009. Where it would lead us is perhaps the greatest unknown and concern for investors today.
Outlook for EM Bonds in a Deteriorating Risk Scenario
With the future unclear for the eurozone and the global economy, investors are evaluating the ability of various sectors, including emerging markets, to withstand a potential steep sell-off in risk assets.
EM interest rates are likely to be a mixed bag. Some countries with relatively high real interest rates will have room to cut policy rates. Of these, Brazil’s central bank has moved the most aggressively, cutting its policy rate by 150 basis points to 11.0% since August 2011. Brazil has signaled it will continue its monetary policy easing cycle if growth weakens further. We believe South Africa and Mexico also have some room to cut policy rates given strong relative credit fundamentals, a comparatively subdued inflation outlook and a generally high sensitivity to the global economic outlook due to their export-driven economies. For key Latin American rates overall, we would expect the front end to rally in a global sell-off; in addition, medium- to long-term rates may fall. With policy rates in major emerging EMEA (Europe, Middle East and Africa) countries such as Turkey and Russia already sharply negative in real terms, we believe only South Africa likely has room to cut rates in the region. It’s a similar picture in Asia, where India and China have either strongly negative real interest rates (India) or slightly negative real rates (China). Indonesia’s real rates are the notable exception in Asia and a monetary easing cycle has already begun.
EM external sovereign debt, along with receiving interest rates in higher-quality EM countries, could be the best relative performers in a deteriorating risk scenario, despite a likely widening in sovereign external debt spreads. Thus far in 2011, EM external sovereign debt has performed well in absolute terms despite some widening in EM sovereign spreads – meaning the asset class’s return this year is likely due to both higher U.S. Treasury prices and the carry (i.e., expected return) embedded in the index’s yield (J.P. Morgan EMBIG – Emerging Markets Bond Index Global). U.S. Treasuries could rally further in an extreme risk-off scenario but how much this may offset potentially wider EM sovereign spreads is unknown. Still, with yields hovering around 6% and strong underlying fundamentals, it’s hard to envision that any dramatic fall in EM external debt would be more than transitory.
In our opinion, EM corporate debt presents a more uncertain outlook. Like EM external sovereign debt, EM corporate debt denominated in U.S. dollars has performed well in absolute terms during 2011 to date despite a widening in credit spreads. Also, like EM sovereign debt, EM corporates generally have relatively strong balance sheets and robust growth prospects. Nevertheless, during periods of extreme risk aversion, the lower relative liquidity of EM corporates will likely produce outsized swings in prices. This volatility could also create opportunities to buy high-quality EM corporate and quasi-sovereign bonds at attractive prices. Our expectation, as with EM sovereign assets, is that our bullish secular outlook on EM corporates is likely to remain intact.
EM Currency Outlook Varies Across Regions
Emerging market currencies would likely sell off sharply in risk-off periods but would also tend to rebound robustly when risk appetite returns. EM currencies are generally floating rather than fixed, meaning they can act as important shock absorbers during periods of instability. This can be a big advantage for EM countries, especially compared with peripheral European countries where the euro functions with the characteristics of an external currency. The flip side is that EM currencies are perhaps the most relatively liquid vehicles by which global investors can reduce their exposure to EM assets. The U.S. dollar still remains the world’s preferred reserve currency, so in times of market turbulence we expect very few EM currencies will be immune to dollar rallies.
Further weakness in Europe would likely hit emerging EMEA currencies the hardest. Not only are these countries the most tightly linked to the eurozone, but some – such as Turkey, South Africa and Hungary – have substantial economic imbalances. Turkey, with its large current account deficit, unorthodox policy mix and high relative inflation may be especially vulnerable; the lira is one of the worst-performing EM currencies year to date. The South African rand may be another vulnerable currency given the country’s heavy reliance on portfolio flows to balance its current account deficit. Although Hungary’s current account is positive, its budget deficit and level of sovereign indebtedness are much worse than most EM countries, pressuring the Hungarian forint. The lira, rand and forint are also frequently traded by hedge funds and other “fast-money” investors seeking not only to profit from the respective countries’ fundamental weaknesses but also to hedge risk exposures elsewhere.
Latin American currencies may not be immune from the eurozone turmoil but could generally perform better than emerging EMEA currencies in a steep sell-off. The Mexican peso is perhaps one of the most vulnerable currencies in the region despite its relative cheapness within the EM currency universe and Mexico’s relatively low current account deficit. Like the currencies of Turkey, South Africa and Hungary, Mexico’s peso trades freely in deliverable form, which means the peso is also a favorite of hedge funds and thus prone to volatility during periods of risk aversion. The Brazilian real may be vulnerable as well, but several factors may damp extreme downside risk: First, the real has already corrected quite a bit this year to date. Second, the 6% entry tax Brazil charges foreigners looking to invest in its local bond markets means that once invested in Brazil, foreigners are generally loath to take money out of the country. Third, among major countries in the developing and developed world, Brazil currently has the world’s highest real interest rates, so shorting the currency becomes an expensive proposition. Finally, Brazil’s Central Bank has already signaled its willingness to deploy more than $350 billion in foreign reserves, providing ample firepower should Brazil need to stabilize the real.
Within the EM currency universe, we believe several Asian currencies are likely to be the best relative performers. Asia is home to exceptionally strong current account surpluses, the world’s largest holder of foreign reserves (i.e., China) and some of the world’s fastest-growing economies. This combined with the managed nature of many regional currencies should make Asian currencies generally the least exposed to a large sell-off in risk. The Chinese yuan has been one of the best performers in the EM universe in 2011, and given its tight management (a source of political tension both within and outside China) it may also be one of the least likely to depreciate against the U.S. dollar. In contrast, India’s rupee – one of this year’s worst-performing EM currencies – may be the most vulnerable in the region given the country’s current account deficit and, more significantly, a central bank with little appetite to push real interest rates into positive territory.
Accounting for these types of regional and fundamental variations can help investors target attractive opportunities in EM currency and fixed income space. A diversified investment approach that incorporates strategic allocations to emerging markets assets may be appropriate in both the near term and over the secular horizon, particularly given the shifting landscape of the global economy today.
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