For Global fixed income investors, what is your biggest call for 2021?
Emerging Markets (EM) Corporates. We think EM corporates will outperform EM sovereign credits. The term “EM fixed income” is typically associated with EM sovereign bonds. Sovereign bonds are the most typical holdings for EM bond investors. The addition of about 30 new frontier markets to the JP Morgan Emerging Market Bond Index Global Diversified over the last decade has increased investors’ exposure to countries that will struggle to recover from COVID. Since the Global Financial Crisis, EM hard currency corporates have outpaced EM hard currency sovereigns in issuance. Nevertheless, EM investors are still largely invested in EM sovereigns, not EM corporates. The EM hard currency corporate market is dominated by Asian issuers, of which more than half are China issuers. Given the V-shaped recovery of China and the positive spillovers onto much of the region, we expect Asia to outperform other EM regions. We also expect Asian corporates to outperform corporates from all other EM regions. When you take into account a yield of about 7.4% in Asia high yield, with help of some credit spread tightening, we are looking at returns of high single digits to 10% next year.
Speaking of Asia high yield, what are your thoughts on some of the recent bond defaults with Chinese issuers?
Defaults are a necessary evil. They are signs of a maturing capital market like that of China’s where participants have to be sophisticated analysts of credit risks to generate superior returns. Investors can no longer just rubber stamp an investment because it has a guarantee or a keepwell agreement from a government entity, even for companies of strategic importance such as semiconductors as in the case of Tsinghua Unigroup. The recent defaults are by companies that share commonalities of weak corporate governance, poor financial performance, and a track record of making questionable investments. By allowing poorly managed companies or ones with unsustainable capital structures to default, the Chinese government is preventing moral hazard and enforcing good governance and fiscal discipline. This has been a consistent goal of Chinese policymakers for over a decade. The importance of discerning credit risk underscores the need to invest with active managers like ourselves, where my job is to avoid defaults and to seek the bonds offering the best risk-adjusted returns.
What are the implications for future defaults?
While the overall default rate in China is rising, it is still low relative to other markets. Because the economy is healthy as it has staged a remarkable recovery from COVID, we see default rates rising but likely to remain in the in low single digits, compared to U.S. high yield, which is around 6% on a 12-months trailing basis.
What are some other key trends to watch in 2021?
Integration of ESG will increasingly become table stakes. The EU Sustainable Finance Taxonomy, expected to be published by end of 2021, should better define, clarify, and harmonize ESG metrics. Active investors will continue to deepen and better articulate intentionality. For us, this means taking a research approach to ESG to identify metrics that have empirically been accretive to returns. This is in addition to using ESG as a risk management tool. I think passive strategies will increasingly explore shifting market capitalization weights to ESG-factor weighs in portfolio construction.
Another key development to watch is in digital currencies. Technology has allowed us to move information seamlessly anywhere in the world at almost zero cost today. But we still can’t move stores of value seamlessly. For example, it takes a couple of days to move currency from Australia to Hong Kong and it’s costly. Even with all the innovation, blockchain and crytocurrency technologies might only be where computers were 40 years ago when we had dial up modems. It would have been hard to imagine ordering takeout from DoorDash while binge watching your favorite series on Netflix given that technology 40 years ago. With governments like China and private consortiums led by organizations like Facebook’s Diem laying down the pipes and the infrastructure to transform our payments, in a few years, we might be able to send money across borders as simply as sending a text message today.
What are the biggest risks you see for 2021?
In the near term, a hard Brexit, but the market appears to be increasingly pricing in this scenario. Over the longer term, I see two key risks:
- Central banks taking the right medicine today causing negative side effects tomorrow. Debt moratoria across many countries deters banks from restructuring bad debt, leaving no balance sheet capacity to provide new credit, further dragging down growth and job creation. Policies to drive down inequality (capping cell phone tariffs, price of oil, etc.) could narrow profitability for some corporates. Central bankers and finance ministers currently have carte blanche to “do whatever it takes,” but prolonged unconventional policies could lead to higher interest rates as investors demand higher risk premia. The combination of unconventional policies, unprecedented high levels of debt are already causing yield curves to bear steepen.
- The 2020’s becomes a lost decade for some frontier markets. In some African and Latin American countries, economic rebounds are only dead cat bounces with the countries unable to achieve take-off velocity. Demand destruction leads to spare capacity, no pricing power, negative profits, job loss, and creates a vicious cycle. Falling recoveries as entire industries default, driving recoveries to below historical averages.
Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets. Securities denominated in a foreign currency are subject to the risk that the value of the foreign currency will increase or decrease against the value of the U.S. dollar.
The J.P. Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets and includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. The EMBI Global defines emerging markets countries with a combination of World Bank-defined per capita income brackets and each country's debt-restructuring history. It is not possible to invest in an index.
As of September 30, 2020, portfolios managed by Matthews Asia did not hold: Tsinghua Unigroup, DoorDash, Inc., Netflix, Inc. or Facebook Inc.
© Matthews Asia
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