Is the run over?
Although some recent reports suggest demand for emerging debt is set to weaken, the popularity of this asset class doesn’t appear to be subsiding. According to April’s report by the International Monetary Fund, rising US interest rates and a falling US dollar threaten to end two years of growth in borrowing by emerging market nations. It has certainly been a boom period. Developing-nation governments and companies have sold $35bn (E29bn) of foreign bonds in 2004, up from $26bn in the first three months of 2003. With average credit quality having edged up to BB+, there remain areas of considerable potential for professional investors.
The spread between investment-grade corporate bonds and US Treasuries has halved in the space of a year. Some analysts are suggesting spreads between emerging and developed nations may have narrowed too much. There has been an overreaction to the re-ratings being given. Standard & Poor’s has raised the debt ratings of Indonesia, Malaysia and Thailand, citing accelerating economic growth and better fiscal positions. Moody’s has upgraded China, Hong Kong, India and Pakistan. JP Morgan’s benchmark EMBI Global emerging-market bond index now has a 40% component of investment grade countries, compared with only about 10% five years ago. The index has gained over 20% in the past year and there appears to be sufficient momentum and technical support for this to continue during 2004.
This year we could see Russia, South Africa, South Korea, Thailand, the Czech Republic, Hungary, Poland and Romania all come to the market with bond issues. As well as sovereign issues, we have the prospect of Petroliam Nasional Berhad, Malaysia’s state oil company and Korea Development Bank, Industrial Development Bank of India and Sri Lanka Telecom all selling debt.
Thanks to improved economic prospects, low borrowing costs and renewed interest in the region, debt offerings in Asia surged to a six-year high in 2003. Comparisons with the Asian crisis highlight mostly how far these countries have progressed in accumulating foreign reserves and improving their banking systems, as part of an overall structural improvement in Asian economies. PIMCO’s Mohammed El-Erian says: “Emerging markets have built up an enormous amount of self-insurance in the form of reserves. Korea has in excess of $100bn, Russia $50bn, Mexico $52bn and Brazil $42bn. This gives these countries a cash cushion that could help them navigate the muted and at times uncertain global environment.”
The IMF says the increase of institutional investors such as pension funds in emerging markets is helping to reduce volatility. One of the greatest concerns is that the strengthening in the outlook for global financial markets might lead to a sense of complacency and intensify the search for yield, while neglecting risks factors.
Economic growth in Latin America is expected to remain near its five-year average of 1.4% in 2004. Economic growth in developing Europe should strengthen modestly, underpinned by slightly stronger economic growth in the EU. Economic growth in developing Asia is expected to slow, driven by increasing protectionism against China’s exports and high regional geopolitical risk. Central Europe has benefited from the attentions of fixed interest investors on the back of the euro convergence story, where expectation for countries such as Hungary and Poland has been high. However, with spendthrift governments, record-high unemployment in Poland and a slowing economy in Hungary, analysts now expect more volatility and little prospect of their meeting EU convergence targets. There has been some rotation away from central Europe, which is benefiting Latin America and parts of Asia. PIMCO sees quite a few opportunities in Latin America, notwithstanding its concerns about Uruguay and Venezuela. El-Erian says: “Our view has been that while central European credits are a good structural bet, they were overvalued from a tactical perspective”.
Developing nations often borrow to the point where they are heavily dependent on foreign capital. At that point, even a minor economic or political event can trigger capital flight out of bonds. Developing markets aren’t yet at the over-investment point.
PIMCO’s Mohammed El-Erian suggests that emerging economies are confronting “an exciting and unstable external environment. It is exciting because they are benefiting from a tremendous positive windfall associated with the surge in commodity prices and the abundance of G-3 liquidity. It is unstable because the related international payments imbalances require what is ultimately an unsustainable leveraging of an increasing number of balance sheets.”
El-Erian believes emerging debt markets still have scope to outperform other bond markets over the medium term. Above all, he is encouraged by the secular improvement in credit fundamentals: “The favourable performance numbers of the past five years reflect the ability of improving fundamentals to overcome internal disruptions (the Russian and Argentinian defaults, the Asian crisis) and an uncertain global environment.”
Nonetheless, as a former executive at the IMF, he understands how complacency can take hold once nations achieve a degree of emergence: “It is sometimes easier for a country to deal with a crisis than to deal with success.” For investors, he suggests the main issue is to continuously update your assessments of individual emerging markets based on what is happening in the global environment: “We live in a very integrated world and if something happens in any of the developed nations, there will be repercussions for the smaller countries.”
At this stage, foreigners’ willingness to fund the US current account deficit does not reflect a charitable inclination towards America and/or international cooperation; it is being sustained by domestic self interest – specifically Asia’s (and particularly China’s) desire to maintain its economic take-off, thereby generating jobs and capturing growing market share; Japan’s desire to minimise any potential dislocation to a recovery process that is gradually developing deeper roots; and Latin America and Russia’s desire to build huge financial reserve cushions, thereby minimising the risk of any slippage back towards debt problems.
But, the very process of sustaining this situation renders it more unstable over time. Indeed, the more the rest of the world succeeds in meeting its domestic objectives, the less willing it will be to fund America’s shortfalls.
Encouragingly though, it is still domestic fundamentals that are the most important factor. Looking forward, analysts expect there will be fewer defaults, and the feeling is that most countries now have good momentum, and that is reflected in the increasing quality of the asset class.
However, S&P doubts this pace can be sustained. In particular, it warns emerging markets are particularly susceptible to geopolitical developments as investors tend to take fright more easily than with developed world events.
“A number of recent adverse geopolitical events-the attempted assassination in Taiwan, presidential impeachment in South Korea, and renewed tension in the Middle East following the assassination of the Hamas leader have already caused consternation,” says Diane Vazza, head of S&P’s Fixed Income Research Group.
S&P warns that many of the positive factors driving investor momentum, cannot be sustained – in particular, with commodity prices at “unprecedented highs since 1990”, further gains over coming months are likely to be modest, magnifying the risk that gains may be more circumspect in the coming months. Any hiccups in the global growth outlook or an unexpected acceleration in interest rates in the US could slow down capital flows to the emerging markets and restrict financing prospects – particularly for weaker-rated borrowers.