Amundi sees continued upside in EM debt
Emerging market bonds have staged an impressive rally this year after being largely out of favour since 2013 – and it is not done yet, argues French fund house Amundi. This has been the first positive return year for the asset class after three difficult years – such performance does not usually evaporate so quickly. So where should investors be focusing their attention?
Over 90% of respondents to an emerging markets poll, conducted by Amundi and AsianInvestor in September/October 2016, believe that Asia offers the best opportunities for emerging market investment (click on chart, left).
Amundi proposes a selective approach to Asia. They are comfortable with Indonesia, Malaysia and India, where they see opportunities particularly on the currency side, and to some extent on the debt side.
In Indonesia, Amundi sees strong momentum as reforms are unveiled. Since coming to power, President Joko Widodo has been able to strengthen his coalition and push through fiscal reforms as well as a reduction in energy subsidies. Changes include a tax amnesty reform bill that is generating inflows into the country.
There has been a significant fall in inflation in Indonesia and the central bank has adopted a credible approach to its rate cut cycle. It is pushing lower short- and long-term inflation expectations, making bonds more attractive.
In Malaysia, the 1MDB scandal continues to be the key political risk due to the knock-on effect that has had on Najib Razak’s premiership – with the possibility of early elections being called in 2017. Among global currencies, the Malaysian ringgit has one of the highest embedded political risk premia, second only to the Mexican peso. The cheap levels of the currency can compensate investors for taking risk in the country.
India is a consensus long in the market, although there is a relatively limited choice available on the debt side. The local bond market is fairly closed off to foreign investors and there is no dollar-denominated debt outstanding. Amundi likes the Indian rupee, which offers a relatively high level of yield and low volatility.
China risks
Amundi perceives tail risks in China, which leads to a more cautious approach to the rest of the region (see also box, Risks on the horizon). They are underweight China itself, as well as countries within Asia perceived as being most exposed to China, such as South Korea, Singapore, Thailand and Taiwan.
Within the fixed income asset class, these countries are among the lowest yielding group in all emerging markets. Therefore the upside for being overweight is small – as is the cost of being underweight. Being underweight there gives an investor the chance to hedge exposure risks emanating from China.
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Risks on the horizon There are any number of concerns among investors at present – among the most prominent are China’s economic slowdown and rising debt, potential interest rate rises (above all in the US) and global political risks. (Click on chart below.)
Amundi’s biggest concern is about debt levels in China’s corporate sector. Debt-to-GDP in China’s corporate sector is about 130% and the pace of debt build-up has been very fast. The Bank for International Settlements published a paper in September saying that countries which seen their debt grow at the same pace as China’s have experienced financial crises. The difference between China and those countries is that the former has been borrowing internally. It therefore does not have an external debt problem. China still generates a large current account surplus and its ability to refinance any external debt is still strong. In addition, a great deal of corporate debt is quasi-government debt. Whilst internalising any debt onto the government’s balance sheet is not a ‘free lunch’, and would affect the country’s credit quality at a government level, it does provide a cushion over the next few years. Potential interest rate rises are a concern of emerging market investors. However, Amundi feels that investors have become increasingly comfortable about the Federal Reserve’s interest rate policy. Political risk is a feature of emerging markets, given they tend to have weaker institutions – ones that yield more political volatility. Amundi thinks that the resolution of uncertainties will play to the advantage of emerging markets. For example, in South Africa this year, the African National Congress received the lowest share of vote since the end of apartheid. This is a reflection of how market-unfriendly policy measures are backfiring. There is a divergence in political dynamics globally. In developed markets (North America and Europe) there are signs of deterioration. This makes emerging markets more attractive, because whilst investors get paid for taking political risk in emerging markets, they do not in developed markets. |
Amundi’s biggest exposure is to Latin America, a relatively unloved region in recent years, in the context of falling commodity prices and rising political risk.
“We have seen a number of improvements. including the stabilisation in commodity prices. The currency depreciations of past years is starting to bear fruit, as exemplified by the significant improvement in Brazil’s current account balance,” said Abbas Ameli-Renani, Global Emerging Markets Strategist at Amundi, who specialises in fixed income.
“Valuations are very attractive. After three years of poor performance, Latin American countries are now compensating investors for the risks.”
A key theme in Latin America is an improving political dynamic. When commodity prices rise, typically governments in emerging markets have abundant fiscal revenue that leads to more spending and a gradual turn leftwards in the political spectrum. As commodity prices fell, loose fiscal policies stopped working and the electorate – in countries like Argentina, Peru and Brazil – saw the inefficiency of that approach.
“Politics is shifting towards a prudent market friendly approach,” says Ameli-Renani. ‘We see that as a positive for the region and we are constructive given current valuations. Our top preferences in Latin America are Argentina and Brazil.’
Debt or equity?
Our poll respondents voted equities as the asset class which will perform best in the next 12 months (click on figure below).
However, the Amundi house view is constructive around both debt and equity. The firm thinks emerging market debt still offers attractive valuations, given that the technical data suggests inflows into emerging market debt can continue – from a position in which most investors are still structurally underweight the asset class.
Moreover, Amundi thinks credit fundamentals are better than the consensus given improvements in current accounts in emerging markets.
Emerging market weakness and sell-offs during the 2013 ‘taper tantrum’ was focused on the ‘Fragile Five’ of Indonesia, South Africa, India, Turkey and Brazil, due to their current account deficits and their high reliance on portfolio inflows to finance those deficits.
An asset class on the radar
In summary, Amundi believes emerging market assets are still far from expensive, given strong fundamentals. Emerging markets are seeing improving political dynamics which should give comfort to investors. There have been strong risk-adjusted returns especially with hard-currency debt and Amundi thinks that segment – where there is no currency risk – is where investors should focus.
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