Emerging Markets

Emerging Market Debt Monthly Update - Nov 2018

December 2018

Risk Disclaimer

Please note that this is a marketing communication and does not constitute investment advice or a recommendation to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. Views are held at the time of preparation.

Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the original amount invested. Securities in emerging markets may involve a higher degree of risk because these markets may be more unstable than developed markets due to regulatory, political, economic and social factors.

Factors influencing the asset class

 
Global equity market volatility remained high during November, and the VIX index averaged 18.07 over the month. Technology shares such as Apple led the way down, although the six-month low point of 2,630 on the S&P500 did not last long as a strong bounce ensued following Federal Reserve (Fed) Chair Powell’s comments that rates were “just below the broad range of estimates of neutral”. This was a meaningful shift from his statement in October that rates were “a long way” from neutral. For the first time since his appointment, Chair Powell has signalled that he will act in line with his predecessors in responding to any significant market weakness, with a relaxation of monetary conditions. A significant factor in the Fed’s thinking may have been the tightening in monetary conditions revealed by the sharp widening in corporate credit spreads during the month. US BBB-rated corporate bond spreads jumped from 156 basis points (bps) to 183bps during the month; US High Yield spreads sold-off by 48bps to 436bps, and European High Yield spreads increased 65bps. Among the main drivers were the travails of certain large issuers (e.g. GE), the drop in oil prices impacting energy companies, and the prospect of the European Central Bank (ECB) exiting from its ESPP buy programme.

US economic data releases also started to show some signs of weakness. Durable goods orders slumped 0.6%; new home sales were surprisingly weak (-8.9%); and General Motors aroused the wrath of President Trump by announcing the closure of six plants, with the loss of 14,700 jobs. The US yield curve flattened, as 10-year yields fell by 15bps to 2.99%. Bund yields slipped 7bps, and the trade-weighted USD held steady against other major currencies.

Having peaked at $76 per barrel in early October, oil prices have since plummeted to hit a low of $50.3 at the end of November. There were a few reasons. Speculative investors had built-up large long positions in oil futures in anticipation of a market squeeze when Iranian sanctions were imposed, but in the event the US granted substantial (but undisclosed) 180-day waivers to the main customers. At the same time, having been flat for six months, according to the US Department of Energy, US crude production leapt by 700,000 barrels in two weeks. OPEC has been left scrambling to agree production cuts among its members, but Russia’s reluctance to contribute leaves most of the burden on Saudi Arabia, which is under pressure from President Trump to keep prices low.

The spread of the J.P. Morgan EMBI Global Diversified Index widened by 30bps to 395bps over the month.

Risk Disclaimer

Please note that this is a marketing communication and does not constitute investment advice or a recommendation to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. Views are held at the time of preparation.

Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the original amount invested. Securities in emerging markets may involve a higher degree of risk because these markets may be more unstable than developed markets due to regulatory, political, economic and social factors.

Emerging market review

 
The Constitutional Chamber of Costa Rica’s Supreme Court ruled that the proposed fiscal reform was compliant with the country’s Constitution, and that only a simple majority was required for its approval in congress. The Alvarado administration welcomed the favourable decision and Congress carried out the required second vote to formally approve the text. The market reacted positively to the news and the country’s spread tightened by 40bps over the month. Although the approved fiscal reform is unlikely to prove sufficient to stabilize the country’s debt levels, President Alvarado remains a willing reformer and there is upside risk in the form of spending cuts, labour reform and ultimately a possible rapprochement with the IMF.

The conflict between Russia and Ukraine flared up again in November, when a flotilla of Ukrainian navy vessels was apprehended, by force, by the Russian navy in the Sea of Azov. The Ukrainian ships were sailing through the Kerch Straight, where Russia built a bridge to directly connect the mainland with the Crimean Peninsula post its annexation in 2014. The incident potentially differs from the lingering proxy war in eastern Ukraine, which has taken on the status of a frozen conflict. On this occasion the Russian and Ukrainian navies were in open confrontation, whilst previously Russia has always denied any involvement by its army or navy. Arguably both sides benefit. Russian president Vladimir Putin has seen his approval ratings fall since the World Cup, as an increase in the pension age has riled supporters, and slow economic growth has meant a significant fall in disposable incomes for ordinary Russians. In Ukraine, President Petro Poroshenko trails his challengers in the polls for the presidential elections – scheduled to take place at the end of March 2019 – and might seek to benefit from the skirmishes in the Sea of Azov by imposing martial law in 10 provinces and stirring up nationalist sentiment.

After his surprise election victory earlier this year, the government of Malaysia’s Prime Minister Mahatir unveiled its first budget, which raised this year’s projected deficit from 2.7% to 3.8%, with plans for a gradual decline to 3.4% next year. What will be vexing the rating agencies is the quality of the fiscal accounts. In line with his election pledge, Mahatir is scrapping the new VAT tax (20% of revenues) and partly plugging the gap by doubling the already large dividend from Petronas, the state-owned oil company. One positive consideration is greater transparency. For example, earlier in the year the government restated the public debt level from 50.8% to 65% of GDP, as it recognised that it will need to service a large share of explicitly guaranteed government debt. Meanwhile the 1MDB scandal continues to roll on, with some chance of recovering $600m or more from Goldman Sachs. Malaysia’s current ratings are A3, A-, A- all with stable outlooks.

Related capability

Emerging Market Equities

EMBI spread and yield
 

 
Source: Bloomberg, J.P. Morgan, Copyright 2018, All rights reserved

Which were the best performing countries in October?

 
The best performers in the month of November were Mozambique (+12.02%), Zambia (+9.94%) and Costa Rica (+4.65%). The worst performing countries were Venezuela (-6.78%), Nigeria (-4.16%) and Ghana (-4.02%).

Country returns (Top and bottom 10)
 

 
Source: Bloomberg, J.P. Morgan, Copyright 2018, All rights reserved

Market outlook

 
Emerging market (EM) growth and exports should continue to benefit from slow but steady growth in developed countries. We expect the US economy to decelerate from here as the lagged effect of monetary tightening takes hold and the fiscal boost wears off. Subdued underlying money and credit growth in many EM countries means that inflationary pressures from recent currency devaluations should be temporary, and many EM currencies have stabilised at levels that are helpful for competitiveness. Some of the worst-hit countries such as Turkey and Argentina are undergoing painful recessions which will nonetheless stabilise their external imbalances, while other countries such as Indonesia, South Africa and Mexico are hiking rates in line with the Federal Reserve.

Oil traders were caught-out by sanctions waivers granted to Iran’s key customers, which coincided with a surge in US crude production, but “OPEC+” should eventually respond to stabilise the market. In China, the monetary loosening measures should start to show up in the money and credit aggregates soon, and start to boost activity by the middle of 2019. However, infrastructure investment is still languishing, and deleveraging within the “shadow” banking sector remains a drag. Trump and Xi’s G20 “deal” to postpone the US import tariff hike for three months is unlikely to represent the end of the trade war, although as the economic costs become more apparent over time, both sides will come under pressure to make concessions. If China chooses a weaker RMB, there could be spill-overs to other EM currencies.

The Fed’s balance sheet is now shrinking by $50bn per month, and the ECB’s QE programme will cease by year-end. This will sustain pressure on those countries more dependent on global capital flows to fund fiscal and external deficits. Nonetheless, the key Central Banks’ policy rates remain very low in real terms, supporting the search for yield, and hence EMD from a technical perspective. Recent comments by Fed Chair Powell have signalled that the near-term peak in rates could be close, which would support EM assets. EM sovereign issuance has already reached $140bn year-to-date, so for most countries, financing needs have been met. EM bond fund flows are quiet, and we believe that global investors remain structurally under-allocated to EM credit. After recent spread widening in the high-yield segment, the J.P. Morgan EMBI Diversified Index spread of 395bps is very wide to the post-Lehman’s average, so valuations are attractive.

We see three main risks to the outlook. Unexpectedly strong US CPI or wage inflation in the US could accelerate interest rate hikes, pushing up the USD and leading to a period of volatility for bond and equity markets. The imposition of a 25% tariff on a wider range of US imports from China could lead to a worsening in tensions, hitting confidence and investment expenditure in either (or both) economies. Finally, although not our base case, evidence of further weakness in the Chinese economy, and a weaker RMB, could hit global commodity prices and have knock-on effects in Asia and Latin America.

 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any products that may be mentioned.

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright 2018, J.P. Morgan Chase & Co. All rights reserved.