Emerging market (EM) debt returned positively in the third quarter, with EM high yield (HY) continuing to outperform EM investment grade.
Emerging market (EM) debt returned 2.6% in the third quarter, (as measured by the index referred to in the table below) with EM high yield (HY) continuing to outperform EM investment grade. EM spreads fell 23bps in the quarter to 287bps and EM HY spreads tightened from 456bps to 423bps as risk appetite and inflows into the asset class remained high. By region, the highest returns came from Latin America (3.2%) followed by Africa (2.9%), with the Middle East region again registering the lowest returns. Issuance out of the Middle East remained high, with Bahrain and Saudi Arabia bringing large sovereign transactions to market. In terms of country performance, El Salvador (+9.7%) was the best performer on the back of signs of co-operation among the largest political parties on fiscal reform. After a research trip to the country, we added exposure to El Salvador in September on an assessment that the likelihood of a political agreement on pension reform was not priced in. From here, we see potential for further country spread compression on market optimism around an International Monetary Fund (IMF) program.
Other high yield credits that performed well during the quarter included a number of less liquid countries: Belize (+7.9%), Suriname (+7.1%) and Mozambique (+7.0%). Within the more liquid universe, Ukraine (+6.7%) and Argentina (+6.3%) had positive performance as idiosyncratic developments drove relative spread compression. In Ukraine slow reform progress continues and the government issued new debt combined with a liability management transaction which smooths the country’s debt profile. Argentine assets benefitted from a better than expected primary election outcome for Macri’s Cambiemos. We continue to be constructive on the longer-term credit trajectory of Argentina and anticipate that the Macri administration should deliver on its structural reform agenda. A strong Cambiemos performance in the election in October should allow the government to implement tax reform, further subsidy reductions and financial sector reform, which should raise Argentina’s growth rate and consolidate its fiscal position.
Although US Treasury yields ended the quarter slightly higher (10 year 3bps higher at 2.33%) – levels of intra-quarter volatility were high, similar to the dynamic in the second quarter. During July and August yields trended lower, recovering from peak levels at the end of June at which time ECB chair Draghi and US Fed president Yellen had hinted at the withdrawal of quantitative easing (QE). The recovery was in part driven by more benign central bank rhetoric around the path of core rates (e.g. out of the Jackson Hole Central Banker Symposium, one of the longest standing central banking conferences in the world) but was also prompted by a ‘flight to quality’ effect, as the market priced in fears of an escalation in US North Korea tensions. The catalyst for a break in this rally, came in mid-September as talk of potential Trump-led tax reform caused a sharp spike in US inflation expectations, pushing US Treasury yields up from a low of 2.04% to 2.33%.
EM fundamental developments
Economic fundamentals in EM showed continued improvement throughout the quarter, with export growth and current accounts strengthening in aggregate. In Latin America, growth improved in most countries, and particularly Argentina and Brazil showed signs of a cyclical recovery. In Brazil, our base case is that President Temer remains in office, but the indictment charges against him will take up time in Congress, which may mean a watered-down pension reform or a postponement of the reform until 2019. The slow reform progress on the fiscal front is counterbalanced by positive news in the external sector where government asset sales have met with strong international interest and Foreign Direct Investment (FDI) is surprising on the upside. In Mexico, the North American Free Trade Agreement (NAFTA) negotiations with the US are progressing slowly, and the market will be watching the US position in the next round of talks. In Colombia, growth seems to have bottomed, but the recovery is weak, and Venezuelan refugees have the potential to become a fiscal drag. However, given Colombia’s underperformance, we are reviewing our underweight position there.
Oil price appreciation during the quarter improved the outlook for potential growth and external balances in Commonwealth of Independent States (CIS) and Middle Eastern countries, although heavy issuance out of the Middle East and North Africa (MENA) region continues to constrain price appreciation in Middle Eastern curves. In Asia, Indonesia continues to exhibit high levels of growth (>5% p.a.) on the back of higher domestic credit growth and an improvement in commodity based export prices. The country’s budget indicates a strong willingness to continue along the path of structural reforms, specifically infrastructure investment which we view as positive in lifting the sustainable potential growth rate in the country. Our assessment at the end of Q3 is that these positive developments are largely priced into bond spreads.
Quasi-sovereign and corporate bonds underperformed sovereign returns during the quarter. However, corporate spreads remained very tight relative to sovereign curves. Corporate issuance at $363 billion has set a record year to date, but this has been absorbed due to strong inflows and low net new issuance versus past periods as well as the fact that credit fundamentals have shown a positive trend which supported valuations.
We expect the external environment for EM debt to remain broadly positive if the following play out: synchronized global growth; a recovery in world trade; contained inflation and a slow unwinding of QE measures by the G7 Central Banks. We see the main risks to the benign outlook in the US, where markets could price in a Trump administration tax reform, which could put pressure on US Treasuries and buoy the dollar. In the second quarter, the weaker dollar was an important tailwind for EM performance; if a strong dollar were to turn into a headwind, this could put upward pressure on spreads, particularly in the high current account deficit countries such as South Africa and Turkey. A further risk to markets is the potential appointment of a successor to Fed chair Yellen, which could lead to uncertainty and nervousness about potential changes of the Fed stance.
Given tight valuations, positive EM performance will be more dependent on continued inflows (demand) into the asset class and a favourable technical picture with low net issuance (supply). Political noise could also come into focus in a number of countries, with the Mexican announcement of Institutional Revolutionary Party (PRI) presidential candidate, Turkey’s reaction to the Kurdistan Regional Government’s (KRG) independence moves and a re-run of the presidential election in Kenya as some events to watch.
Annual Performance (% in GBP) to 30 September 2017
These figures refer to the past. Past performance is not a reliable indicator of future results. For investors based in countries with currencies other than the share class currency, the return may increase or decrease as a result of currency fluctuations.
Performance data is calculated on a net basis by deducting fees incurred at fund level (e.g. the management and administration fee) and other costs charged to the fund (e.g. transaction and custody costs), save that it does not take account of initial charges or switching fees (if any). Income reinvested is included on a net of tax basis. Source: Lipper IM / First State Investments (UK) Limited.
*Hedging transactions are designed to reduce currency risk for investors. There is no guarantee that the hedging will be totally successful or that it can eliminate currency risk entirely.
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