- The attractive fundamentals of many EM countries should continue to support EM assets over the longer term.
- However, the recent sell-off in EM bonds and currencies highlights the fact that these markets are not immune to global economic and market forces.
- The EM team at Western Asset believes recent market volatility has created an opportune moment for value investors to initiate or add to their EM exposures.
- In local EM markets we favor exposures to countries where we have seen a significant upward adjustment in yields and where carry and rolldown remain attractive.
- Western Asset’s view of slow but steady growth in the DM world combined with continued supportive monetary policy globally is, we believe, a supportive backdrop for EM growth and asset prices.
The attractive fundamentals of many emerging market (EM) countries—including stronger relative growth, demographics, productivity catch-up and healthy balance sheets—are well known and, we believe, should continue to support EM assets over the longer term. However, the sharp sell-off in EM bonds and currencies since May highlights that this is not a one-way trend and that these markets are not immune to global economic and market forces.
In our view, concerns over the normalization of US Federal Reserve (Fed) monetary policy caught the EM sector at a vulnerable time. Declining growth expectations throughout the sector (and in particular fears over a Chinese hard landing) served to further unnerve investors who were already concerned with valuations in the context of higher US rates. And while some of the structural vulnerabilities among certain EM countries are nothing new, selling pressure exacerbated by recent outflows from the asset class has brought these back into sharp focus. As long-term value investors, we are interested in whether current pricing in EM bonds and currencies correctly reflects underlying fundamentals and whether they offer attractive opportunities to generate returns.
Underpinning our assessment of valuations is our central view that while the eventual “tapering” of asset purchases by the Fed will remove an important element of support for developed market (DM) bond yields, the broad backdrop of moderate (but improving) growth, continued policy accommodation by the major central banks, benign developed world inflation and some evidence that Chinese growth is stabilizing should be broadly supportive of risk markets. This includes EM at these current “cheaper” levels. In addition, EM-specific factors such as flexible exchange rate regimes, large foreign exchange reserves, generally low levels of external debt (particularly short-term external debt), lower levels of inflation and monetary policy flexibility bring comfort to EM investors that 2013 is not a replay of the balance of payments crises seen in the 1990s.
External Debt (USD-denominated Sovereign and Corporate Debt)
Although the future normalization of US monetary policy brings new challenges to EM policymakers, particularly with respect to the impact of capital flows on bond yields and currency levels, we believe sovereigns are generally well positioned to weather the storm and have plenty of policy levers to ease the transition. Very few EM countries are default candidates, and although there may be some ratings pressure among more vulnerable countries, we do not see downgrades to speculative grade; in fact, we still forecast ratings upgrades over the coming year, e.g., in the Philippines.
EM external debt, like other spread sectors, is valued as a spread over US Treasuries. There is a US rates component and a spread/credit risk component to the all-in yield. In our view—particularly as we are not forecasting negative ratings actions—the back-up in external debt spreads relative to comparables makes valuations attractive at current levels.
Exhibit 1 illustrates the widening in investment-grade-rated EM sovereign bonds relative to similarly-rated US corporate bonds. Although EM spreads on an absolute basis are far from the highs seen during past crises, we haven’t seen current relative spread levels since 2004. A discount of approximately 125 basis points (bps) to the US Credit Index seems to offer good value given our view that the market is correctly discounting a low probability of severe sovereign strain.
We also believe that recent market volatility has created attractive opportunities within EM corporate bonds. When rating EM corporate credit issuers, ratings agencies rightly take into consideration country risk. However, typically a “strong” corporate issuer will receive a lower rating than a comparable DM bond due to the domicile of issuance. In addition, despite many EM companies being “under-rated” for the standalone strength of their balance sheets (Exhibit 2a), EM corporate bonds trade wide to DM comparables on a ratings basis (Exhibit 2b). A nimble manager will be able to pick through credits using top-down and bottom-up expertise to discern those credits that may benefit from the recent local currency weakness and those that may be more vulnerable.
Local Currency and Bond Markets
Local bond yields (both in nominal and real yield terms—Exhibits 3 and 4, respectively) and EM currencies (Exhibit 5) in particular have borne the brunt of the recent sell-off. In the short run, we recognize that currency weakness and higher local bond yields are necessary “pressure valves” as slower EM growth and a normalization of US monetary policy are priced in. However, with the Fed’s intention to taper asset purchases now discounted by the market and with EM growth recently showing signs of stabilizing, we believe the dramatic sell-off of local currencies and rates merits a closer look.
Although the current environment is challenging for policymakers, we take some comfort in the fact that a number of central banks such as Indonesia and Brazil ”get it” and have already responded by tightening policy. Over the medium term, weaker currencies and higher bond yields, combined in some cases with more sound fiscal policies should help to address imbalances and stabilize exchange rates. In those countries where policymakers think their currencies and rates have moved disproportionately to fundamentals, central banks have moved into action. The Brazilian central bank, for example, is implementing a plan to supply dollars to the market via swaps/credit lines to try and ease liquidity pressures. By potentially offering up approximately a quarter of their foreign exchange (FX) reserves, Brazilian authorities are sending a powerful message to investors who try and short the currency as well as reducing volatility. As a result, negative positioning in Brazil is much more expensive in light of central bank action.
The exhibits below show the 10-year history of selected currencies versus the US dollar. In the cases of the Brazilian real, South African rand and the Turkish lira, currencies have moved close to or beyond levels seen during the global financial crisis in 2008.
Even under “normal” market conditions, trying to estimate the fair value of a currency can be a complex and imprecise exercise, but one simple metric we can look at to try to ascertain whether a currency has moved out of line with its long-term fundamentals is to look at changes in that country’s real effective exchange rate (REER).
Economic theory supports the idea that faster-growing EM countries, where productivity levels are playing ”catch up” with DM countries, should see their currencies appreciate over the long term. One of the best-known theories is the “Balassa-Samuelson” effect, which states that countries with higher productivity in the tradeable sector of the economy (e.g., manufactured goods) will have higher wages in that sector than a country with lower levels of productivity. This should put upward pressure on wages in the non-tradeable sector (e.g., local services) by more than the tradeable sector where prices adjust through international competition. This raises the overall price level relative to the country with lower productivity, resulting in an appreciation in the real exchange rate.
A rise in a country’s real exchange rate was a feature of a number of EM currencies prior to the 2008 financial crisis (see exhibits below). In most cases the real exchange rate started to recover after a significant downward adjustment.
In the cases of South Africa and Turkey (and to a lesser extent Brazil), a common trend has been that they have run persistent current account deficits (a country’s net position in trade, services and income) suggesting that their exchange rates were “overvalued” prior to the recent weakness. Such “overvaluation” can often be sustained if the current account deficit is funded by long-term foreign direct investment. However, if the deficit has mainly been funded primarily by short-term portfolio flows (as is the case in both South Africa and Turkey) then this “overvaluation” is difficult to sustain.
The country that has seen the largest adjustment in its real effective exchange rate is South Africa, a decline which started in 2011 and has continued since. The sharp fall in South Africa’s REER should start to help restore competitiveness within the country’s export sector, and over time, help correct the current account deficit. By contrast, the declines in the REERs in Turkey and Brazil have been more modest. The REERs in both Poland and Mexico have never really recovered post the financial crisis and remain below 2008 levels.
A recent study of EM REER valuations (Exhibit 8) highlights that the South African rand, Polish zloty and Mexican peso are ”undervalued.” Other currencies that stand out as “cheap” on this measure include the Indian rupee and Malaysian ringgit.
Similarly, comparing changes in a country’s REER (Exhibit 9) with changes in their nominal effective exchange rate (NEER) highlights that a number of EM currencies appear to be undervalued.
In local EM markets, we favor exposure to countries where we have seen a significant upward adjustment in yields and where carry and rolldown remain attractive. In currencies, we favor “quality” EM currencies which have suffered during the indiscriminate recent sell-off in EM FX and which still appear undervalued on a REER basis, such as the Mexican peso. The table below is a summary of various scenarios for a US dollar-based investor looking to take a position today in 10-year maturity Mexican bonds (current yield 5.75%) and the peso (i.e., an unhedged bond position) over a 12-month horizon.
Investor Positioning Remains Supportive
With uncertainty over Fed policy and the global growth outlook subsiding, headwinds to positioning in local EM bonds should start to abate. Western Asset’s view of a slow but steady recovery in the US and in other major DM economies, and a gradual retreat from quantitative easing, combined with improving data from China, should all generally be supportive of EM currencies and local bonds.
Despite increased volatility, foreign investors have not reduced their EM local market exposures (Exhibit 9). Although some pundits point to the dangers of offshore positioning within domestic bond markets, we believe this positioning reflects broader positive trends. The fact that offshore investors have not materially reduced local positioning (despite ample opportunity) likely reflects their ongoing belief in the long-term fundamentals of the assets class and suggests they are not concerned about a repeat of previous EM crises. In addition, investors are likely finding local EM investments still attractive within their wider opportunity set. We also believe many investors are still structurally “underweight” EM fixed-income and therefore are less inclined to unwind positions.
EM assets have experienced a significant sell-off since early May. For a long-term investor, this re-pricing has created attractive value opportunities across the EM bond and currency universe. Western Asset’s view of slow but steady growth in the DM world combined with continued supportive monetary policy globally is, we believe, a supportive backdrop for EM growth and asset prices. The recent indiscriminate sell-off in USD-denominated EM sovereign and corporate bonds has, we believe, made yield spreads compared to similarly-rated DM bonds look attractive. Local currency-denominated EM bonds, which combine the potential for both lower yields and stronger currencies also, in our opinion, represent an attractive opportunity for those investors who have a constructive long-term view and are able and willing to accept shorter-term volatility. The EM Team at Western Asset believes recent market volatility has created an opportune moment for value investors to initiate or add to their EM exposures.