Fixed income quarterly outlook: Time to scale in emerging local debt

Fixed income quarterly outlook: Time to scale in emerging local debt

18-04-2016 | Quarterly outlook

Having been cautious on the asset class for years, we are becoming more constructive on local emerging debt because of its attractive valuations, the first signs of inflows back into the asset class and a recent improvement in fundamentals.

  • Kommer van Trigt
    van Trigt
    Portfolio manager, Head of Global Fixed Income Macro
  • Stephan  van IJzendoorn
    van IJzendoorn
    Senior portfolio manager Global Fixed Income Macro
  • Paul  van der Worp
    van der Worp
    Portfolio Manager Fixed Income

Speed read

  • Increasingly constructive on emerging debt
  • More and more cautious on peripheral government debt
  • Selective in credits, with a preference for Europe and subordinated financials

For many years now, emerging local debt markets have been in the eye of the storm. The impact of the Chinese growth slowdown was felt most in emerging economies which are often highly dependent on commodity prices. A looming string of rate hikes by the Fed also had a depressing effect on these markets, particularly on the exchange rates (versus the US dollar). Years of underperformance resulted in ever more appealing valuation levels for the asset class, but consistent outflows in combination with deteriorating fundamentals kept us from re-entering this market segment. So what has changed?

First of all, in recent months the Fed has turned much more dovish, adjusting its growth forecast downwards and stressing global risks to its growth and inflation outlook. This means further rate increases – if any - will likely take place only very gradually. This will halt the strong US dollar appreciation versus emerging currencies and potentially lure investors back into this market.

Secondly, fears of an imminent Chinese hard landing have receded as the country moved back from focusing on rebalancing the economy to reflating the economy. The approach has helped the local property market to recover dramatically (Shanghai house prices are up 20% this year) and demand for raw material is up on the back of it. Risks of a one-off large renminbi depreciation have abated as outflows continue, but at a more moderate pace. In effect the PBOC is pursuing a policy that has become known as “ease and squeeze”, i.e. easing monetary policy conditions and squeezing the “speculators” who short the RMB.

We also see the first signs of prudent macro-economic policy by central banks (mainly in Latin American countries like Colombia, Peru and Mexico) as they hike interest rates to address the issue of increasing inflation due to rising import prices, despite this being a drag on economic growth. Finally, investor surveys highlight that emerging local debt is underowned after years of underperformance and fund outflows. At the same time, fund flow data show the first signs of net inflow into the asset class. So from a technical perspective this is encouraging.

Although these are positive signs that all support an allocation to the asset class, we do recognize that significant risks remain. First and foremost in China. The PBOC is doing an effective job in managing the short-term challenges of the economic slowdown, but China’s twin problems of high corporate debt and continued excess capacity in the state-owned enterprises have not been resolved and the government’s credit policy further increases the leverage in the economy. Tackling these problems will likely be accompanied by painful structural changes. Another source of risk is the vulnerability of emerging markets to external shocks, particularly to a sudden re-emergence of USD strength if the Fed is forced to hike sooner than what markets are pricing in. Stay tuned.

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Our other key themes for the second quarter are:

  • Growth depends on the consumer
    The global macro-economic environment is fragile. Economic growth largely depends on the consumers’ ability to spend as governments’ and corporates’ willingness to spend more is low and inventories are already high. However, without signs of wage increases and an increase in the savings ratio consumer spending is unlikely to pick up. We therefore stick with our low growth and low inflation scenario. In this environment an imminent bond market sell-off looks unlikely.  The interest rate risk in the portfolios is biased towards longer dated bonds.

  • Be selective within credits: focus remains on Europe and subordinated financials
    The US economy is in a more advanced stage than Europe, which also manifests itself in more balance sheet risks for US corporates. The picture for Europe still looks somewhat different, although corporates may take the benefit of the ECB buying program by issuing more debt. The subordinated financial sector remains our favorite. Increased regulation has improved transparency and reduced risk taking in the sector. From a bond holder perspective this is favorable. Issuer selection in the category remains key. We prefer banks that either have solid capital ratios or capital ratios that are clearly improving.

  • Increasingly constructive on emerging local debt
    After years in the doldrums emerging market valuations have become quite compelling. Now that the Fed has turned less hawkish and emerging market debt (EMD) outflows have stalled or even turned the corner, it is time to benefit from the valuations and improvements in some fundamentals. One of the main risks to the position is China. China is doing an effective job managing the short-term challenges of the economic slowdown, but the long-term challenges remain unresolved.

  • Increasingly cautious on peripheral government debt
    We expect peripheral government bonds to lag in performance. Valuation looks rich in the light of deteriorating fundamentals. Political uncertainty is on the rise. Spain and Ireland haven’t been able to form new governments. Greek political leaders and the Portuguese minority government are publically challenging demands from official institutions.  Market positioning is still biased to longs in these markets.

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