Navigating emerging markets debt in a currency driven world

Jonathan Boyd

We currently tend to prefer emerging markets credit and that position is based on several factors.

Firstly, if we look at valuations, they are attractive, particularly relative to developed markets. Compared with their own history emerging market spreads are towards the high end of the 5 yr range.

Technical factors are supporting emerging markets credit as well. For example, there remains a lot of liquidity across EM markets, against a backdrop where investors are seeking both yield and diversification. This is evidenced by significant positive inflows into the asset class recently.

Meanwhile, extraordinarily low interest rates across developed markets are anchoring yields incredibly low, particularly in Europe, which makes the yield on emerging markets even higher by comparison.

Another reason for our preference for emerging markets credit is that it is denominated in US dollars and will tend to benefit from the strengthening of the currency and search for dollar assets, which is otherwise a fundamental headwind for the overall EM asset class.

Within EM credit we have a preference for higher credit quality. For example, we tend to lean towards commodity importers, sovereigns with strong balance sheets and corporates with less cyclicality. We also monitor for promising turnaround stories that have the potential to be very profitable, such as reformed countries.

We can’t deny that broadly the EM space is facing significant challenges. However, we would argue that they are largely priced in. There may be more adjustment to come, particularly as the timing for a US Federal reserve rate increase remains in question, but we think credit will do relatively better as the bulk of the adjustment will happen in the local currency market.

When we think about the broader challenges, we have to consider the strong US dollar as a major factor. Historically it has been a negative for margins and a negative for the balance sheets. However, it is worth remembering that this is not new ‘news’ and it is largely priced into market expectations. A second macro headwind for EM is commodities, which have weighed on overall performance. It is not all bad because 75% of EM economies actually tend to benefit from lower commodity prices.

Nevertheless, investor sentiment tends to link weak commodity prices with EM weakness. We’ve seen a fair amount of adjustment already which is the good news, but we probably still have more to go. The final headwind for emerging market economies is the pattern of economic divergence, with developed markets outperforming and emerging markets economic growth continuing to deteriorate due to the deleveraging across EM countries such as China, which continues to attempt to rebalance their economy to be less dependent on credit, translating into lower growth in economies in EM. Again, we are pricing that in slowly but surely.

Given all of this, it makes sense to prefer higher quality credit and seek countries and issuers who are better positioned to ride out the business cycle, protected from commodity exposure and have strong balance sheets. So where are we finding opportunities?

We are bullish in on Hungary as a solid country with fiscal discipline, current account surplus, and a strong beneficiary of the European economic recovery. They have built up reserves, growth is picking up and it is a turnaround story as well. We like Mexico as it benefits from the recovery in the US. It’s also seen significant market friendly reforms and should continue to get a tailwind from greater US economic momentum.

At the same time, we also own more cyclical countries that are in the right place in the cycle such as Argentina, which is a turnaround story. They have a major catalyst at the end of this year with an election, which is expected to potentially usher in a more market friendly regime, bringing about a return to normalisation. Investors are also extremely well compensated for taking risks in that market with yields about 10%.

Lebanon is another slightly usual pick. It fits into a broader credit barbell strategy at play in our fund, in which we balance exposure at the two ends of the curve. At the front end of the yield curve we like exposure to higher yielding bonds that offer carry without as much duration risk, which will be important as the Fed moves towards its first rate hike. We expect limited duration bonds to have less vulnerability to Fed driven volatility and so are investing in 1 and 2 year bonds in Lebanon, which offers liquidity and an attractive risk/return profile.

Whilst we anticipate riding the front end strategy through Fed volatility, we also quite like the back end of the yield curve, where duration has sold off and looks attractive. In EMD the back end of the yield curve is extremely steep given investor concerns about duration, meaning that opportunities with 7 or 8 per cent yield are available. Certainly we remain cognisant of Fed and Treasury risk down the line, but we manage that by hedging with Treasury futures and being quite tactical and nimble with these positions.

Of course currency volatility remains a huge factor for emerging markets. We feel the bulk of the adjustments will continue to be felt in local currency markets and therefore prefer USD denominated debt. Overall the strengthening of the US dollar is general bearish for EM currencies and there is no reason to go against that trend, hence we are essentially hedged to be neutral to EM currency risk, with some important exceptions in areas like Mexico, Poland and India where we think there are interesting opportunities. However, for the most part, we think there is more pressure to come from emerging market currencies and whilst we may like local bonds we are constrained by the FX.


Pierre-Yves Bareau is manager of the JP Morgan Funds – Emerging Markets Strategic Bond Fund.

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