From Zero to Hero to Villain to Hero Again: The Story of Emerging-Market Debt
9th November 2015
As far as movies go, this is the one about a nobody who becomes a saviour and then a pariah – all before redeeming himself as a hero by the end. At least that’s the script.
From zero to hero
The plot begins like this: for many years, emerging-market debt (EMD) was a struggling asset class, considered volatile and peripheral enough to be stacked behind high-yield bonds.
Then emerging-market (EM) countries began to reform, and their solvency and ratings improved, attracting a first wave of early investors. Indeed, the commodity supercycle was born on the heels of China’s voracious appetite for raw materials, which it needed to sustain its colossal investment program. All EM countries benefitted, and the economic windfall lifted EM issues to the investment grade universe. As EM productivity began to drop, Lehman Brothers’ 2008 collapse triggered an unprecedented monetary accommodation that resulted in the current mispricing of assets.
In a world where finding attractive returns continues to be elusive, EMD had become an attractive asset-allocation choice because it offered an appreciable premium over similarly rated assets. On the evidence of the positive top-down factors, this was the right approach.
From hero to villain
Unfortunately, the EMs began to unravel with the lethal combination of the sudden collapse in oil prices and the “surprising” deceleration in China’s growth. These two events are actually the corollary of sluggish global growth, declining productivity and rising geopolitical and idiosyncratic risks, with financial repression in the background. Throw into the mix a bribery scandal in Brazil that refuses to go away, a war in eastern Ukraine pitting Russia against the West, and political turmoil in Turkey, among other things, and the EM shine begins to wear off.
EMD has sharply sold off, with USD 21 billion leaving the asset class during the third quarter of 2015 alone. Not since Lehman’s collapse have we witnessed these outflow dynamics. EM spreads blew out, on average, 150 basis points in the last 12 months (through September 2015) on the back of real and imaginary risks.
Although oil represents 38 per cent of the EMBI Global Diversified Index*, the reverse correlation between oil and EM spreads has reached 90 per cent in the last year. Many commodity countries that are located in Africa and Central Asia have seen material deterioration in their spreads.
There is no doubt that oil remaining lower for longer, and/or China’s growth decelerating below 5 per cent – if it isn’t there already – will have material consequences on EM credit quality. We are waiting for a long list of downgrades next year.
Undoubtedly, this is the time when the financial press has its field day, announcing with weekly frequency the demise of EMs. With every EM sovereign downgrade below investment grade, a number of rules-based investors may become forced sellers into a structurally illiquid market – the result of tighter banking limits to warehouse risk. Recall the case of a Brazilian energy company that was recently downgraded, causing index players to dump billions of dollars’ worth of bonds. As a result, spreads to Brazil’s sovereign debt ceiling significantly widened due to the kind of repricing that we believe can only be explained by a hefty liquidity premium.
From villain to hero
As EMs have become less fashionable these days, we believe it is a good time to differentiate fact from myth.
Myth 1. Growth deceleration and the fact that EMs are more ballast than engine for global growth. This is one lesson that EM policymakers should take note of, as real reform stopped five years ago, when opportunities for economic diversification were missed. EM countries need to regain the initiative to attract capital with robust reform agendas that foster competitiveness by focusing on economic liberalisation, rule of law and infrastructure building.
Myth 2. Capital outflows out of EMs are setting the stage for the next funding crisis. This is not the 1990s, and EM countries have long abandoned fixed or crawling-peg foreign exchange (FX) policies. In addition, inflation is largely under control, and EMs are even benefitting from global disinflation. Furthermore, domestic capital markets have accumulated USD 14 trillion and counting, and reserves are still at high levels. You can safely conclude that sovereign balance sheets are in good shape, net of any potential fiscal slippage over the next two years.
Myth 3. Staggering growth of USD debt in EMs.
Most “tourist” investors fret about the EMD overhang and its potential to trigger another EM crisis. What these investors overlook is the fact that half of this USD debt is quasi-sovereign in nature, and that EM governments have no option but to own these debts, if need be. The vast majority of this debt is concentrated in countries with high FX reserves, with China, Hong Kong, Brazil, Mexico and Russia accounting for 60 per cent. Make no mistake, this is not the next systemic crisis, and if needed, EM governments would actively use their reserves to bail out their banks or quasi-sovereigns.
Also, courtesy of this financial repression, EM corporates have been able to refinance their debt maturities to 10 years or longer, with funding costs and coupons that are the lowest in history. There is not a lot of front-end refinancing pressure, unless a country truly derails economically.
Myth 4. If not growth, then value. We are in a bear cycle for EMs for the next year or so, and some more downgrades are coming our way. Certainly there will be more spread volatility. However, the EM correction does not change the current context of financial repression in a slow-growth environment. EM investment-grade assets now offer 400 basis points. With investors now sitting on the cash they raised from their redemptions, the question is: what next? Value, it is often said, lies in the eye of the beholder. And you, what do you think? Will the movie’s hero be redeemed – and make good?
Source of all data (unless otherwise stated): Allianz Global Investors as at October 2015
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