Understanding governance and social pressure points are paramount in managing emerging markets portfolio risk, explains Francesc Balcells.
There’s no question that emerging markets and US Federal Reserve hiking cycles are not good to travel companions. Since the Latin American debt crisis of the 1980s, emerging markets (EM) has incurred crisis after crisis every time the FED has tightened liquidity.
This is hardly a surprise. Countries as dependent on global liquidity conditions and as levered to global growth as those from emerging markets will unavoidably suffer a fair amount of stress as the FED pulls the proverbial punchbowl.
The question, however, is threefold: one, are those stresses exclusive to EM? Two, how representative or systemic are they for the whole EM debt asset class? And, three, are those stresses already priced-in by the market?
For all the negative headlines on EM – from Russia to Sri Lanka, Turkey to Ecuador – emerging market debt is hardly the only fixed-income asset class suffering in the current environment.
The spread of EM dollar bonds over US Treasuries, a measure of credit risk, is 125bps wider year-to-date. For comparison, spreads in US high-yield corporate credits, another debt asset class in which EM is normally benchmarked, are 169bps wider year-to-date.
“The spread of EM dollar bonds over US Treasuries, a measure of credit risk, is 125bps wider year-to-date.”
On a total-return basis, which includes returns from spread as well as interest rates, EM has indeed underperformed, but that’s because EM dollar bonds are longer-dated than their developed market high-yield counterparts, which means they have a higher sensitivity to changes in US interest rates and spreads. More than half of the negative return in EM debt year-to-date is due to interest rate risk, not spread risk.
This has been a global interest rate shock, not an EM debt crisis. How can the EM spread outperform with such negative headlines as Sri Lanka and Russia’s? Basically, because there’s much more in EM than meets the eye. In market cap terms, more than half of the EM debt bellwether index is now investment-grade rated or high-quality credits.
Twenty per cent of the benchmark is made up of the Gulf countries, including the likes of Saudi Arabia, Qatar, Kuwait, and UAE, which barely have any debt and hold trillions in foreign assets. That’s EM too.
The reality is that EM has become a bifurcated asset class, with the majority of credits exhibiting decent balance sheets, particularly relative to developed markets, and better growth prospects. Importantly, most of these credits operate today in a very different fashion than they did back in the ‘80s, ‘90s and early 2000s.
For a start, exchange rates are flexible, providing an escape valve against external shocks. Meanwhile, local markets have become the main source of funding (as opposed to external debt), reducing the vulnerability to potential balance sheet currency mismatches.
In other words, most EM today is better prepared to withstand a FED hiking cycle. There is, however, another EM, one which still operates under the old paradigm of fixed or semifixed exchange rates, having an almost exclusive reliance on foreign currency borrowing, poor debt structures, and subjugation to Chinese lending.
This is where Sri Lanka, Pakistan, and Zambia come to mind. The size of that bucket of risk depends on how it is measured, but we think it ranges between 10-15% of the EM debt investment universe.
More significantly, however, that sliver of risk is already trading at levels consistent with a fair amount of distress. Sri Lanka trades at 26 cents to the dollar, Argentina at 19 cents, Tunisia at 55 cents, and the list goes on.
The average spread for sub-investment grade credits in EM, a broader list which includes nondistressed names as well, is presently at 900bps, or a yield of 12% in USD.
At the very least, current pricing shows a more favourable balance of risks for those more fundamentally challenged credits. Does that mean it’s all priced-in and ready to go? Of course not; the global environment remains extremely challenging, and some countries will default no matter the value proposition in terms of yield.
“…current pricing shows a more favourable balance of risks for those more fundamentally challenged credits.”
Indeed, political and social risks have always featured prominently in EM investing. This is particularly the case today. Events in Russia show how sudden political and geopolitical changes can rapidly upset a seemingly solid credit.
This is why understanding governance and social pressure points in particular countries is of paramount importance in managing EM portfolio risk. Combining this experience with historical market knowledge and penetrating financial analysis of current credits needs to inform the investment decision process and help investors take advantage of the most attractive EM opportunities today.
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