Striking a Balance Risks and Opportunities in Emerging Market Debt

While we anticipate risk to remain elevated, emerging market debt continues to offer compelling, albeit selective, opportunities for investors.

Emerging markets continue to face a number of challenges stemming both from the external environment and from country-specific developments. In the following interview, portfolio manager Francesc Balcells and product manager Anton Dombrovsky speak to the rise in recent volatility, current developments and the continued, albeit selective, attractiveness of this asset class.

Q: When discussing emerging market debt, what are the concerns voiced by investors?Dombrovsky: Following a challenging period for performance in 2013 that saw significant outflows from emerging market debt since last June, investors have been raising legitimate concerns about the heightened volatility and whether the emerging markets story is still valid, and more importantly, whether tapering of the U.S. Federal Reserve’s (Fed) quantitative easing (QE) programme will result in a permanent reversal of capital flows to emerging markets.

At the same time, as emerging market sovereign index spreads (represented by JPMorgan EMBIG) were again approaching 400 basis points (bps) over U.S. Treasuries at the end of January 2014 and the emerging market local debt index yield (represented by JPMorgan GBI-EM Global Diversified) moved to about 7%, another group of investors has been highlighting much improved valuations and considering entering or increasing the allocation to emerging market debt.

Q: What are the drivers behind the recent volatility in emerging markets?
Balcells: It has been a confluence of factors. By its very nature, emerging markets have always been a high beta play on global liquidity. As liquidity is scaled back, emerging markets disproportionately suffer, especially considering where valuations were prior to the Fed’s “taper” announcement in May 2013.

Notice, however, this is nothing new: Every time the Fed has removed monetary accommodation in the past, it has been followed by some form of emerging market turbulence. That was true in the early 1980s and mid-1990s, and again in the early 2000s. We are now seeing a repeat of such periodic turbulence.

Another contributing factor has been slower growth in China as the country’s leadership has refused to reflate growth at any cost, focusing instead on rebalancing the economy, which may be the right approach. This is having a disproportionate effect on the commodity complex, a major component of emerging market economies. The increased importance of growth in China to other emerging markets has introduced a new phenomenon: For the first time, a recovery in the developed markets, albeit tepid and not uniform, is not spurring a recovery in emerging markets.

And finally, there has been a rise in idiosyncratic risk, especially in the form of political and social risk in countries as diverse as Egypt, Turkey and Argentina, to name a few. More recently, the developments in Ukraine have clearly elevated the importance of geopolitical risk.

Q: Should investors expect a repetition of an emerging-market-wide crisis? And if not, why? 
Balcells: We do not think so.

We believe the risk of such an event taking place is greatly diminished as the initial conditions of emerging market countries nowadays are quite different. Taking into account foreign exchange reserves and the level of debt and its composition, balance sheets of emerging market economies are generally in much better shape today than they were in the past. They have more local currency debt and less external debt, and the debt itself has longer maturities. Overall, this has significantly improved policy flexibility, putting many countries in a much stronger position. For that reason, we think that any parallels with the 1997–1998 emerging markets crisis are misplaced.

The biggest difference between then and now is exchange rate flexibility. Over the past few months, exchange rates have been used as a “release valve”. This is no different from what we see in the likes of the Australian dollar, the New Zealand dollar and the Canadian dollar, where no one equates the foreign exchange adjustment to a financial accident. We think the same applies for most of the emerging market countries – though not all.

While this is not 1997, this does not mean there are no vulnerable credits out there. Some countries – those with large external imbalances, pervasive foreign exchange mismatches in the economy or that lack “insurance”, e.g., not enough foreign exchange reserves – will continue to be vulnerable in this environment where liquidity is slowly being withdrawn.

Q: In this context, can the performance of weak countries contaminate stronger ones?Balcells: While there is some risk of contamination, it is important to recognise three key factors.

First, the countries that are most vulnerable, such as Ukraine or Argentina, are relatively small from a systemic perspective due to limited trade and financial links to the rest of the emerging market economies.

Second, the global financial architecture is better prepared today to respond to financial shocks. For example, a number of emerging countries like Poland and Mexico have International Monetary Fund credit facilities. At the same time, global central banks have been quick to provide foreign exchange swap lines to a number of emerging market countries when they needed them; we think that will continue to be the case going forward.

And third, the largest emerging market economies, such as China, Mexico, Russia and Brazil, have relatively pristine balance sheets, even if we recognise there has been deterioration in recent years. The balance sheet can act both as the conduit between market dynamics and a deterioration of fundamentals, or as a firewall between the two if the balance sheet is healthy. In case of the latter, we as investors can live with the mark-to-market volatility in the financially strong countries, or even take advantage of it, knowing that at the end of the day fundamentals will reassert themselves.

Q: Who are the predominant buyers and sellers of emerging market debt currently?Dombrovsky: While it is hard sometimes to differentiate among the types of investors, retail investors have been by far the biggest sellers of emerging market securities. This group of investors is more sensitive to short-term volatility, drawdowns and headline risk. Conversely, dedicated institutional investors are less sensitive to noise and consider emerging markets longer-term investments: In fact, we observed several large institutional investors taking advantage of more attractive valuations to enter the market at the height of the crisis last year. And the proof in the pudding is that, despite a significant exit in local markets by retail investors, the share of foreign ownership in the local markets has remained broadly unchanged, suggesting a fair amount of substitution from retail to institutional investors.

Longer term, we expect large institutional investors, such as sovereign wealth funds and insurance companies, to continue increasing their strategic allocations to emerging market debt in their portfolios.

Q: Looking ahead, what are the positive triggers you are monitoring in emerging markets?
Balcells: First and foremost, we look at valuations: Are they compelling enough versus the underlying risk for investors to return to emerging markets? On a relative basis, we think emerging market external debt looks attractive. We believe for investors not to see a positive total return this year, one has to come up with fairly adverse scenarios for spreads and U.S. Treasury yields. Likewise, for emerging market local-currency-denominated debt, the yield (measured by the JPMorgan GBI-EM Global Diversified index) is now close to 7%, or almost 200 bps higher than nine months ago, while emerging markets inflation has barely risen by 0.25% over the same period. In other words, we have seen a big upward adjustment in real yields. The spread between emerging market local yields and G-10 yields is now running at almost 500 bps.

Another key factor we consider is whether the growth gap between emerging and developed economies is still present. While the gap has narrowed a bit given the recovery in the U.S. and the slowdown in China and the rest of the emerging market economies, we expect the emerging markets growth advantage to persist.

Third, we focus on how emerging market countries deal with their external imbalances. Although there is still a lot to do for several emerging market central banks and governments, we have already seen positive adjustments in countries like Indonesia.

Finally, we keep a close eye on the remaining two triggers – technical and idiosyncratic risks – as they may continue to negatively affect the performance and keep volatility in the markets on the current elevated level. Given these two latter risks, and especially in light of the increased geopolitical risk, we remain cautiously positioned and stress the importance of differentiation by focusing on countries that are likely to be the least affected by the negative market dynamics and potential contamination from weaker countries.

Dombrovsky: More recently, some investors are again exhibiting a growing appetite for adding emerging market debt exposure. While it may not yet be the time to go ahead full throttle in emerging markets, at PIMCO we have been adding some risk in a very selective and differentiated manner, taking advantage of attractive valuations, both in absolute but especially in relative terms. In doing so, investors would need to feel comfortable underwriting the volatility ahead, which we think will continue to be elevated in the months to come.

We believe such a differentiated approach to investing in emerging market debt is best facilitated by the ability to invest across different sectors of this asset class – sovereign, corporate, denominated in hard or local currencies – as well as in a variety of instruments emerging markets currently offer. Combined with rigorous risk management and an experienced investment team, such an investment approach is key to successfully navigate emerging market debt.

The Author

Anton Dombrovsky

Product Strategist, Emerging Markets and Multi-Sector Credit

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