There has been a series of market wobbles so far this year. The volatility shock in February, the technology stock price shock in March and an emerging market shock in the last couple of weeks. Are these related? Is it a consequence of the end of super-easy money in the US? Or it is just positioning and crowded trades? The consensus view is that the global economy remains in good shape and it is difficult to argue with that, save for some weakness in first quarter data. However, there comes a time when monetary tightening becomes the more important factor than a slowing derivative of economic activity. In addition, geo-politics and the bubbling trade war is perhaps far from priced in. Market returns are “flattish” so far in 2018. If growth is still strong they could recover. However, investors should consider the possibility a summer of disappointment (and not just for England football fans) if US yields keep rising above 3%.
Who’s makin’ da’monies?
Almost all asset classes have displayed a significant deterioration in their risk adjusted returns over the last year. This is certainly the case for the major equity indices and the most popular fixed income strategies. Investment returns are cyclical and we are in a period where returns are flat at best, but where volatility has also been increasing. On the basis of past cycles, it looks as though it could get worse before it gets better. Also on the basis of past cycles, the trough of the investment cycle – where returns adjusted by volatility are at their worst – usually coincides with a slower economy, if not a recession. The common feature of previous cyclical troughs in investment returns has been an increase in interest rates. With the US Treasury yield hitting 3% again this week and the Federal Reserve (Fed) set to raise interest rates further, the rate environment might remain a significant obstacle to investment returns improving soon.
An emerging market saga
Emerging market debt is one area that has shown a significant deterioration in performance since the beginning of the year. Total return bond indices are showing declines of up to almost 5% with even the relatively better performing Asian fixed income indices down between 2.5% and 3.0%. This of course comes after two very strong years for emerging market debt in both hard currency and local currency terms. In a recently published report, the Institute for International Finance (IIF) points out that non-resident portfolio capital inflows to emerging market debt reached a record $315bn in 2017. They forecast a lower number in 2018 which is consistent with other market data showing portfolio outflows in recent weeks. While there are always many moving parts when it comes to analysing emerging markets, there are two fundamental factors at play – higher US interest rates and a stronger dollar. In addition, there have been some country specific stories that have amalgamated to significantly hit investor sentiment (new sanctions on Russia, Argentina approaching the International Monetary Fund (IMF) for help, Turkey seeing the lira hit a record low against the US dollar and heightened political tensions in the middle east which have pushed oil prices higher).
The 2016-2017 period was very supportive for emerging markets. First there was the recovery from the commodities and China-led recession of 2015. Second there was the firming of global growth at a time when global interest rates remained extremely low and the dollar was stable. The confidence that this encouraged led to a rapid rise in emerging market external borrowing, mostly in foreign currency. This was absorbed by significant capital flows to the asset class – over $430bn flowed to emerging market debt over that two-year period. Spreads on emerging market hard currency debt fell significantly during the period – depending on which reference index is used the decline in spread was of the magnitude of 250 basis points (bps) to 300 bps. Commodity exporting countries did better as global prices rose while manufacturing based economies benefitted from the upward trajectory of global GDP growth. Moreover, there was optimism on economic reform in countries like Argentina and Brazil. In aggregate, current account balances declined allowing foreign exchange reserves to stabilise and currencies to strengthen.
…lead to expensive assets
The rise in external debt in emerging markets has increased the vulnerability – all else being equal – to a higher dollar and higher US interest rates. This is not a new thing in emerging markets. Countries that have high levels of hard currency, external debt are particularly vulnerable especially where there are economic imbalances – current account deficits, fiscal problems or high inflation. Countries with significant amounts of government debt denominated in foreign currency include Argentina (43.3%), Colombia (34.3%), Hungary and Poland, while 68% of Turkish debt is denominated in foreign currency (corporate and financials as well as government debt). So when US interest rates are higher, the attractiveness of emerging market dollar denominated debt relative to US Treasuries is diminished. If investor sentiment is also turning negative this can have a powerful impact on flows. Our own analysis suggests that about half of the (negative) total return from emerging market debt since the beginning of the year has resulted from the rise in Treasury yields. The rest comes from rising risk premiums on emerging market assets as seen by the increase in spreads. It should be noted that any escalation of protectionism, especially between the US and China, could have very negative implications for emerging markets, especially where supply chains are linked to China. Given the uncertainty surrounding President Trump’s negotiating style, it is difficult for markets to price in negative scenarios but anything that hits global trade volumes is more than likely going to lead to a worsening emerging market trade balance. At the same time, heightened risk premiums in the oil market suggest that some oil producers will be clear winners in the short term.
What are the arguments for holding on to a position or adding to a position in emerging market debt? The first is that the asset class has got cheaper. Spreads are now slightly above their long-term average with all-in yields much higher than at the start of the year (nearly 8% for EM high yield and 5% for investment grade). A portfolio of short duration emerging market bonds can now yield between 4.5% and 5.0% compared to around 3.5% at the end of last year. Secondly, the deterioration in performance has already been quite severe. An indicator of the quality of returns is the rolling 12-month return divided by the rolling 12-month volatility. This most recently peaked at the end of 2017 (4% y/y return per each unit of volatility) but is now down to zero. In previous bear markets there has been a run of negative annual returns, which we have not seen yet, but that could be coming in the short-run even if the market goes sideways from current levels. Thirdly, the fundamental story still has some legs. Growth is doing well in emerging economies and many of the bigger economies do still have some policy flexibility to offset market weakness or any signs of growth slowing down.
Depends on US rates
The positive scenario for EM from here is that there is progress on some of the policy issues (Argentina can get help quickly from the IMF, Turkey can boost the credibility of its central bank), that the risk-on environment can be sustained and that US yields don’t increase much further. The 3% level in 10-year US Treasuries seems a tough level to crack in the short-term and the benign consumer price inflation data for April gave the bond market a reason to rally away from the 3% level. If US yields and the dollar remained stable, emerging market bonds can probably perform again given the sell-off and higher yields. The JP Morgan EMBI Diversified Sovereign index is already down close to 5% this year so far. That index has never had a full calendar year performance worse than that – even in 2009 the total return for the year was just -2.4%. However, that masks some large drawdowns such as a 7.6% loss in Q3 2013 (taper tantrum) and an 18% loss in Q4 2008 (liquidity crisis). The point being that this could be a correction but that there is little guarantee the correction is over. Medium term, however, I strongly believe in a role for emerging markets in a global fixed income portfolio. It provides additional yield relative to other hard currency assets, diversification if local currency exposure is sought and the ability to take advantage of macro-economic factors that differ from developed markets. Moreover, structurally China will become a very important component of global fixed income once its bonds are included in some of the key global indices.
Noises in my head
Are there canaries in the coal mine and are markets generally ignoring them? In recent years there seems to have always been things to worry about but low interest rates, quantitative easing and gradually improving global growth have sustained market returns. I might be over-cooking some signals but typically a big emerging market economy going to the IMF for assistance is not a good sign, nor is the potential for a populist Italian government hell-bent on spending and taking a different route to the Brussels orthodoxy. Remember Draghi said he would do whatever it takes to save the euro largely because of what was going on in Italy in 2012. It could be Italy again that poses the biggest challenge to the European Central Bank as it looks for a way to escape negative interest rates. On a cross currency basis, long-dated Italian government bonds are the cheapest G10 (sovereign) bond asset. There’s a reason for that. The second cheapest are German bunds because hedged back into US dollars they yield more than US Treasuries. Growth data was softer in Q1 and inflation still can’t seem to get a foothold in the major economies. I do like the idea of having some long duration in the bond portfolio as a hedge against “risk-on” turning to ”risk-off” this summer.
Come on Boss
Well, another season almost over. Forget the actual football, it was heart-warming to see the huge show of support throughout the game for Sir Alex Ferguson after it was revealed he suffered a brain haemorrhage recently. Thankfully the news about his recovery is positive. He is the “godfather” of world football and held in enormous respect by past and present players, coaches and commentators alike. I was lucky enough to meet him on a couple of occasions, once being invited into his private room following a home game against QPR in 2012. He made me and my family extremely welcome (in no part due to my wife sharing the same birthday and both coming from Glasgow) and it was obvious he was an extremely generous and sociable person. Here’s hoping he makes a strong recovery. A victory in the FA Cup final against Chelsea would surely help that.
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