March 2011

FOOD FOR THOUGHT: political unrest and bond yields

Food_for_thoughtBlame the political uprisings in the Mena region for a drop in emerging market local currency debt yields at your peril, writes Fiona Rintoul. This asset class is more resilient than you think

What goes up must come down, as Newton’s law of gravity tells us, and emerging market (EM) local currency bonds were up in pretty much every conceivable way in 2010. Real yields on local currency EM debt were compelling versus bond yields in developed markets, and local currency debt accounted for more than half of the record cumulative inflows into EM debt in 2010 of US$75.1bn (€54.3bn) – almost double the previous high of US$41.9bn in 2007.

But now a political crisis is unfolding in the Mena (Middle East and North Africa) region whose ultimate trajectory is impossible to predict. Is this the signal for local currency EM debt to head in a southerly direction?

Food inflation
There have been substantial outflows from EM equities this year. And while outflows from EM bonds have been more muted, predictions from some fixed income analysts at the beginning of the year that inflows to EM bonds in 2011 would equal those in 2010 are starting to look optimistic. However, to suggest that this is all to do with the crisis in the Mena region would be foolhardy.

“Developments in the Middle East are not necessarily the main driver,” says Sergio Trigo Paz, chief investment officer for EM debt at BNP Paribas Investment Partners. “North Africa makes up only 5% of the external debt index and only 0.5% of the local index.”

Instead, says Trigo Paz, the main drivers of EM price action – food inflation and developed world growth catching up with EM growth – were already in place before the Mena crisis began. Which is not to say that crisis is not important. It is. But it is part of a global picture where social pressure is an increasingly important factor for investors to consider – and not just in the emerging markets.

“We take a qualitative approach in emerging markets and one area where it’s important for us to have good information is social pressure,” says Trigo Paz. “We see social pressure through popular uprisings in emerging markets where there is food inflation. We also expect social pressure in the developed world later this year and early next year.”

Peter Marber, global head of EM debt at HSBC Global Asset Management, endorses this view, pointing out that the “last gasps of revolution against autocracy in places that haven’t seen much growth during one the of the greatest growth spurts homo sapiens has ever seen” as seen recently in North Africa were long overdue.

Asset class
He also suggests that some of the doomsayers in the market may be jaundiced Europeans, rattled more by what’s happening in their own backyard than by popular uprisings in Egypt and Libya. “When you’re a hammer, everything looks like a nail,” says Marber. “Europeans’ projections and pessimistic world view has a lot to do with the eurozone.”

Perhaps, then, the most that can be said about the Mena crisis as things stand is that it has added to the overall sum of political risk around the world and has heightened already existing fears.

“Long before the Mena unrest we already had this fear in the emerging world about inflation,” says Sébastien Thénard, fund manager in the EM team at Natixis Asset Management. “The fear was present before the crisis, and the crisis is just exacerbating it.”

Or, as Kevin Daly, portfolio manager on the EM fixed income team at Aberdeen Asset Management put it: “It’s just another negative, just another reason to reduce exposure to emerging markets or not to buy.”

So, what is the outlook for local currency EM debt in this context?

Many analysts suggest that a key factor in the asset class’s comparative resilience so far this year has been its depth. EM local currency debt is an asset class that barely existed before 2004, but the range of liquid securities available in local markets has expanded rapidly since then. Inflation-linked bonds are now available in eleven emerging market economies, and a growing number of local markets has a sizeable pool of tradable corporate bonds. In fact, according to recent JP Morgan research, corporate issuance accounted for more than twice the level of sovereign issuance across the EM bond sector in 2010.

The market value of the JP Morgan GBIEM Broad Index, which tracks locally issued debt, has risen steadily since 2004 and had reached US$1.4bn by the end of 2010, while broadly level. According to figures from JP Morgan and Bank of America Merrill Lynch, the market capitalisation of EM local bonds was US$6.5trn (€4.6trn) at the end of 2010, compared with US$1.5trn for hard currency bonds (see table). EM debt overall accounts for 20% of global bond market capitalisation of which 10% is investable.

“You can play these markets from so many different perspectives,” says Marber, who remains optimistic about EM local currency debt this year, while conceding that “you might not see what you saw last year”.

However, while it is true that EM debt is now a more complex asset class and that it is possible to rebalance within it, Daly raises the spectre of liquidity: “There are diversification opportunities, but you need to be aware of liquidity. Peru is 2% and Mexico is 10%; therefore there is a lot more liquidity in Mexico.”

But whatever challenges this asset class may face, a consideration for investors thinking about quitting it, says Brigitte Le Bris, head of global fixed income and currency at Natixis Asset Management, is: where to go? At the moment, average yields on local currency EM debt are 7.2% with ratings of triple B-plus. Profit-taking may explain the outflows that have started to occur, but for investors who want to remain invested, finding another home for their money could be tricky. “It’s interesting that they have these two characteristics at the same time,” says Thénard. “We know investors have little patience. That’s what we see on the equity side. But on the fixed income side, it’s more difficult to see such a big reallocation, because where else will you find yields of 7%?”

A potential game-changer is Libya, the ninth largest oil producer in the world and the largest in Africa. If the crisis there is not resolved speedily, and at the time of writing there is no reason to think it will be, then there will be upwards pressure on oil prices.

Opinion is divided as to how problematic this would be for EM local currency debt. Daly says that some of the concerns in terms of oil supply can be addressed by Saudi Arabia increasing production, and that inflation is a bigger (though, of course, not unconnected) risk for emerging markets.

Trigo Paz points out that higher oil prices will benefit the 60% of emerging markets that are commodity and oil exporters, and that if oil prices do rise sharply then the game changes for the whole world, not just emerging markets.

Marber notes that a key concern connected to rising oil prices (and, indeed, inflation) – interest rate hikes in the United States – may not be as much of a negative factor as some people assume.

“Everyone is concerned that higher oil prices and higher inflation could lead to rising US interest rates, which isn’t good for bond prices,” he says. “But rising interest rates in local markets is good for currencies that are undervalued.”

Perhaps the most immediate consideration for this asset class is not what is going to happen next in Libya, or anywhere else, but how the authorities in the different emerging markets are going to deal with what happens. Everyone knows that the fundamentals in the leading emerging markets in terms of growth and debt ratios are good. They now need to prove that they can handle the challenges of inflation rising in the face of global political uncertainty.

“For the first time these markets have to test the credibility of their central banks,” says Thénard. “These banks now have to prove they can manage a situation where growth is still there but not accelerating and they have to manage inflation.”

A related problem is a lack of co-ordination among the emerging markets.

“Every country is adopting its own policies to deal with the situation,” says Daly, while Marber registers disappointment that more did not come out of the G20 meeting at a time when more multi-lateral co-ordination is needed.

With so much diversification where it is not wanted – in central bank policy – an important call for EM local currency debt fund managers is working out who has got it right. Turkey, for example, a net oil importer, is pursuing a policy Daly describes as “experimental”. It is up to the canny fund manager to divine whether it will work.

“Key right now to making moves is understanding which countries are making the right policy decisions,” says Marber.  “We’d like to see countries implement anti-inflationary policies, but a fair amount of intervention is going in the opposite direction.”

©2011 funds europe