Emerging Market Debt: Sentiments drown out sense
The political and economic uncertainty surrounding Turkey and Argentina is distracting investors from the sound fundamentals to be found elsewhere across the asset class
- Rising US interest rates and trade tensions have exerted downward pressure
- Argentina and Turkey have dominated emerging market news
- Most emerging markets are stronger since the 2013 taper tantrum
- The potential for changes in sentiment complicates local currency debt investment
This year has seen a reversal in sentiment regarding emerging market debt (EMD). By the third quarter, local currency drawdowns were close to the worst seen since the benchmark was created in 2003, greater than in the taper tantrum of 2013. Hard currency spreads of 370bps over US Treasuries in mid-September, were troubling peaks last reached in 2013.
Rob Drijkoningen, co-head of EMD at Neuberger Berman, points out that the widening of hard currency spreads against US high-yield bond spreads has been more striking (see figure). Hard currency spreads surpassed US high yield for the first time since 2005. Given that over half the hard currency market is rated investment grade, it illustrates the dominance of sentiment over fundamentals in emerging markets.
Investors seeing the emerging markets sell-off may be pondering what lies ahead. “We have seen this movie before. But the main characters always seem to change and the plot thickens each time,” says Anders Faergermann, an EMD portfolio manager at PineBridge Investments. Sentiment in emerging markets driven by headline news, often seems divorced from fundamentals. Currently, it is Turkey and Argentina that dominate the bad news. But investors need to be able to separate idiosyncratic stories from the underlying fundamentals. At the end of the day, says Faergemann, markets are likely to calm and reverse back up into next year: “In the current environment however, it is not time to be a hero.”
There are certainly economic drivers that have created headwinds for emerging markets. First, US interest rates have risen steadily since 2015. “Emerging market investors were unnerved earlier this year when the yield on US 10-year Treasuries went past 3% yield,” says Sergei Strigo, co-head of EMD at Amundi.
The significant negative performance in EMD across all classes came from April with a broad-based sell-off after dollar appreciation. That put pressure on emerging market currencies, which caused an underperformance in hard currency EMD. The Trump administration’s trade strategy is also causing uncertainties, particularly regarding the impact on China. Strigo says: “The continuous threat of more and more tariffs on China may slow Chinese growth, and hence several EM countries, particularly in Asia where there are smaller open economies dependent on global trade.” He also points to political uncertainties arising from a heavy election schedule in 2018 in Mexico, Malaysia, Turkey and Brazil, where it is unclear who is going to win, which has added to investor discomfort.
Separating emotion from analysis is difficult in emerging markets. But emotional breakdowns can only last so long before reason takes over. Drijkoningen has never seen more than one quarter of net outflows when considering the aggregate capital accounts of all emerging markets. Institutional investors tend to be anticyclical and steady but retail investment is fickle. “They tend to be the marginal players and determine whether we need to withdraw investment from the market even if we like it,” he says.
Headlines that may not reflect the whole market impact sentiment among retail investors and that leads to outflows irrespective of fundamentals, and some institutional type investors follow the mood. “Asset allocators also tend to see the downside and withdraw as markets go down and think they have done a good trade,” says Drijkoningen. “But that can then leave them in a worse position as they then have to figure out when to get back in,”
The question as to whether the EMD markets will get cheaper is difficult to answer. It is not fundamentals that will drive the market but sentiments. In that scenario, Amundi favours hard currency debt over local currency as the volatility is likely to be lower. It is currency risks that are causing bond market volatility. As Strigo says: “We can’t see any short-term reasons for the US dollar to weaken, so EM currencies will trade at these levels or weaker over next few months”.
Bad news bears mask progress
Turkey and Argentina have contributed most to investor worries. They face financing current account deficits and repaying external debt in a global environment of tightening finance. But, as Steffen Reichold, portfolio manager at Stone Harbor Investment Partners, points out, Turkey and Argentina stand out in terms of vulnerabilities. They both have current account balances of about 5% of GDP and substantial external debt burdens.
Most other emerging market economies have adjusted significantly since the 2013 taper tantrum. Emerging markets excluding China, have adjusted from an average 1.5% GDP deficit to a balanced budget. Emerging market countries have also improved debt structures with higher shares of domestic funding by governments and longer maturity profiles. Central banks have managed to control inflation, opening up local currency funding allowing domestic borrowers to also extend maturities of debt at reasonable rates.
EM currencies have also depreciated back to levels prevailing in the late 1990s and early 2000s (adjusting for inflation and trade-weighted). Reichold sees the strong performance of EM economies since then as highlighting the strong competitiveness of EM exchange rates. Local interest rates are also at multi-year highs in real terms and higher than the taper tantrum. These factors bode well for EM local currency debt markets he says.
“Asset allocators also tend to see the downside and withdraw as markets go down and think they have done a good trade”
If fundamentals look good, when will sentiments catch up? The idiosyncratic stories around Argentina and Turkey are certainly an important cause of negative sentiment. But the fear of contagion is not justified and even with these two, there are arguments that negative sentiment has been overdone.
“We don’t see a risk of sovereign default on hard currency debt by Turkey. It has a diversified economy and relatively low government debt. The debt is mainly on the corporate side and the currency is vulnerable,” says Strigo. In Argentina, all eyes are on the International Monetary Fund and any revisions to its bailout package.
Pinebridge says Argentina should be able to repay its loans and emerge in a stronger position. The risks for the country are political and how they address the economy’s eventual hard landing.
What will break the negative cycle of sentiment that afflicts emerging market debt is a stabilisation of the news regarding Turkey and Argentina. “Better news out of Turkey with some policy actions by the central bank and potentially positive news over Argentina and the IMF further payments will provide short-term triggers for the market to either stabilise or in some cases to potentially get back some of the performance,” says Strigo.
For investors, timing any reinvestment into EMD, particularly local currency debt, will be difficult as they will be held hostage to rapid changes in sentiment off the back of unpredictable politics. But the size of the adjustment in exchange rates and interest rates bodes well for the long-run economic and market success of EMs, says Reichold. Few would disagree.