Weighing EM value versus credit risk in 2016

Emerging markets will offer relative value opportunities in 2016, but investors should also think about de-risking amid rising default risk as the credit cycle nears its end, an AsianInvestor forum heard.

Penny Foley, group managing director for emerging markets at TCW, pointed to dollar-denominated EM debt as an area of continued interest next year, with upside potential for EM equities and currencies.

Speaking at AsianInvestor’s seventh annual Southeast Asia Institutional Investment Forum, she estimated average GDP growth of 4.1% or 4.2% for emerging markets in 2016, ranging from Russia and Ukraine on the low side to Mexico and India at the other end of the scale.

Foley underlined improved EM fundamentals since the 1997-98 Asian financial crisis, with short-term external debt-to-GDP having fallen 50% in the last 20 years. She noted public sector debt to GDP for emerging markets stood at 48% today, versus 120% two decades ago.

Moreover, 75% of EM sovereign debt is denominated in local currencies now, with emerging markets controlling 80% of the world’s reserves (enabling them to pursue countercyclical policies in the event of global contraction).

Foley noted emerging market debt in dollar terms had been one of the best performing fixed income asset classes over the past couple of years, and year-to-date was performing in line with many equity markets.

She cited structural reforms as a differentiator in terms of country risk, with the three best performing markets this year – Argentina, Venezuela and Ukraine – driven by political change or the hope of political change.

She was also relatively sanguine on EM commodity sensitivity, forecasting that oil would trade in a range of $40 to $45 a barrel, with upside risk starting in the second and third quarter next year.

She acknowledged local currency was an area of potential weakness, with local currency EM debt having underperformed its hard currency equivalent by 30 percentage points in the past two years on the back of currency volatility. Continued FX volatility remains a risk.

But she said history showed that when the US Federal Reserve started to raise interest rates – with a decision scheduled for December 16 – and that rise was well signposted, “consistently you see a rollover [of debt] in dollars. We would expect a similar experience this time.”

Given how under-owned EM securities are by global investors – OECD pension funds allocate 4-6% to EM – Foley sees the flows and positioning story as well supported.

“We think dollar debt is likely to continue to provide one of the best risk-adjusted returns in fixed income in 2016,” she stated.

She added that EM equities should interest investors next year given they were cheap on a price-earnings and book-value basis. “It is under-owned and really disliked. We see a better growth environment and FX stability, so EM equities could be an interesting source of alpha for 2016.”

Any leverage concerns came in the private sector, Foley said, with EM corporate debt the fastest growing segment in the international dollar market, of which Chinese firms made up about 50%.

“We think there is a lot of idiosyncratic risk built into this segment, so our weighting in corporates and total return strategy is at the low end,” she acknowledged.

But she noted the quality of corporate balance sheets had improved and that growth in the sector had largely been fuelled by refinancing short-term bank debt. The fact a number of domestic companies earned their revenues in local currency would bear watching.

“We are in a deleveraging phase, the end of the credit cycle, and default risk is on the rise, but we don’t think it is a systemic risk,” she said.

Justin Bourgette, portfolio manager for Eaton Vance, had earlier given an address on building a robust high-yield and loan portfolio. He, too, noted the credit cycle was in its latter stages, with leverage at an all-time high.

He observed that trailing default rates had started to pick up, from about 2% over the past two years to 3% now, and said it could be appropriate for investors to de-risk portfolios.

“I hate to tell investors to invest in cash because it is so low-yielding, but that is an opportunity cost on buying assets cheaper in future,” he stated.

He added investors could look to move up the capital structure into investment grade credit and tailor their exposure to BBs rather than CCCs given that the latter is more exposed to default risk.

While BB-rated bonds carry greater interest-rate risk, Bourgette cautioned that “even if we do get a [Fed] rate hike, you have to have three to four hikes before you see a higher coupon, so this may not be a 2016 event”.

He acknowledged there had been a lot of talk about lack of liquidity in the corporate credit market, noting that in 2008 dealers had $300 billion of bonds on their balance sheets, or 10% of the corporate market, but that had since fallen to just $10 million in the corporate market.

But he argued that illiquidity was simply a price that changed over time. “You might not like the price you are getting, but you can still trade in these markets. You may just have to take a step down. The price of liquidity is higher and I don’t mind capturing that as a long-term investor.”