Co-Head of Emerging Markets Debt Relative
A robust start to the new year for emerging market debt holds a promise of better times. But nothing much will happen until there is more clarity over China’s economic future, writes Jim Barrineau, our emerging market debt specialist.
Dollar emerging market (EM) debt started the new year down only slightly. You would not expect to read that sentence in the context of a US equity fall of over 5%, losses of more than 6% losses in European equities and a 7% drop in Japan’s Nikkei stock index. A rally in US Treasuries has helped fixed income in general, but US high-yield returns have also remained relatively robust, giving investors some hope that obviously cheap asset classes still represent reasonable propositions even in a stormy environment.
The proximate cause of these upheavals was, of course, Chinese turmoil over the authorities’ botched equity interventions and the falling currency—a near carbon copy of late August 2015, when global asset prices reacted in a similar manner. That episode was followed by a recovery until December’s falls, which were probably exacerbated by the US Federal Reserve’s decision to raise interest rates.
This time we think the China jitters may be more extended. If the Chinese have chosen faster than expected currency depreciation over boosting credit and other policies as a meaningful instrument of economic expansion, the falling currency will continue to be an issue for investors with limited risk appetites. Though the near-term move in the renminbi looks steep on the chart (see attached), the total depreciation since mid-August is only just over 3%. Most observers believe that a depreciation of more than 10% would be required to provide any real help for the country’s ailing manufacturing sector. For context, keep in mind that other emerging market currencies are now down by about 50% since mid-2013. However, bear in mind that the Chinese still have substantial firepower to defend the renminbi: December’s fall in reserves of $108 billion is very large in a historical context but total reserves remain comfortably over $3 trillion.
Perhaps one of the biggest issues for markets is the near-total lack of clarity on what Chinese officials are thinking: what is their view of a fair level for the currency, how much capital flight are they willing to endure, how does the currency fit into a coherent medium-term growth strategy? Perhaps some of the answers will shortly be forthcoming following the recent turmoil. However, the Chinese authorities’ intervention in equity markets, with poorly constructed circuit breakers being switched on and off randomly, does not give confidence that the answers, even if offered, will assuage tense investors.
Just as they have been for some time, currencies will be the main shock absorbers for emerging markets. We note plenty more commentary as the year began acknowledging how cheap EM currencies have become, but we doubt they can rally without adequate resolution of the China issue, if not also a stabilisation of commodity prices. Valuing currencies is a fool’s game, but we do believe that the eventual gains on currencies currently being hit by investors’ lack of risk appetite only means that future gains will be that much fatter once the negative drivers dissipate. The day will come when they will likely be viewed as one of only a handful of opportunities offering solid double-digit returns in a low growth world (with that recognition coming only in hindsight, of course!)
For now, though, the full opportunity set of emerging market assets offers dollar debt with investment grade spreads near historical highs of 300 basis points. An example of the value represented here arose in a discussion with our high-yield trader colleague late last week when he suggested that yields for EM investment grade opportunities are now in many cases equivalent to CCC rated US high-yield debt. In this context we see value emerging especially in Latin America, which has been in the eye of the storm as commodity prices collapsed and it became the worst-performing region of the year. This year, the region may actually be out of the spotlight, broadly speaking, as Asia grapples with the renminbi fallout, while European emerging markets seem pretty fully valued.
Our tone may seem quite dour, but the clarity of the issues facing markets – and EM – should allow investors a better opportunity to identify turning points for already cheap assets. Broad EM growth is largely stabilizing outside of Brazil, and current account deficits continue to shrink. Meanwhile debt issuance is likely to be moderate by historical standards and some buybacks are likely to occur to take advantage of our low interest rate world. So the raw material for recovery is being moulded, even as more fully valued global asset classes, like equities, look set to suffer disproportionately compared to a large part of the EM debt asset class.