Emerging Market Debt Monthly Update

October 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

 
October saw a significant wave of selling hit equity markets, leading to the worst monthly performance for the S&P500 since 2011 (-6.95%). The supposedly cheaper valuations of other equity markets did not help cushion their performance: the Euro Stoxx (-5.9%), Nikkei (-9.1%), FTSE100 (-5.1%), and the MSCI-EM (-8.78%) suffered equally. The most likely reasons for the equity correction include: the effect of rising interest rates, especially real rates (the 10yr US TIPS yield jumped 35bps in 2 months); a valuation correction for technology shares (NASDAQ fell 9.20%); rising odds of recession in the next few quarters; and of course, the usual suspicions of algorithmic
trading strategies.

Contagion to fixed-income markets was relatively limited. The US 10-year treasury yield increased 8bps, so there was only a very muted “flight-to-quality.” Credit spreads reacted a little more with US High Grade BBB corporate spreads 16bps wider on the month but this was still a fairly mild response, helped by a slowdown in corporate bond issuance and the relatively small weight of technology-related sectors in bond indices. With the strong performance of the US economy, the effect of leveraged merger and acquisition (M&A) transactions means that rating downgrades of US corporate bonds have been double the rate of upgrades this year.

US economic data releases confirmed a gradually tightening labour market. The unemployment rate dropped from 3.9% to 3.7%, while the quarterly Employment Cost Index, which adjusts for changes in the structure of occupations, accelerated from 2.5% a year ago to 2.8% in the third quarter. Given the build-up of inflationary pressures, the Federal Reserve (Fed) signalled that it will stick to its path of raising interest rates. Recent comments from Chairman Powell and voting-member Williams, hinted at more uncertainty about the level of the “terminal rate”, arguably de-anchoring long-term rates. The Fed was impassive in the face of heightened pressure from President Trump to stop tightening, e.g. his comment that the Fed had “gone crazy”.

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.

Italian spreads over Germany widened as much as 50bps early in the month after the new Italian coalition government proposed an increase in the fiscal deficit to 2.4% of GDP next year, in an attempt to boost economic growth. Policy measures were heavily skewed towards higher spending, rather than lower taxes, and also proposed a controversial cut in the retirement age. The budget will likely trigger an “excessive deficit procedure” from the European Commission, and has already attracted a rating downgrade by Moody’s, to BBB-. There was little sign of contagion to other Euro sovereigns, but with Chancellor Merkel soon to leave the political stage, and the ongoing rift between Brussels and Hungary/Poland, political risk looks set to remain elevated in Europe.

US high grade corporate bond spreads widened 16bps to 157bps during October, while high yield spreads jumped 50bps to 388bps. This compares with a spread widening of 31bps for the J.P. Morgan EMBI Global Diversified Index.
 

Emerging market review

 
In Brazil, former army captain Jair Bolsonaro won the presidential election in a second-round run-off with 55% of the vote compared to 45% for his opponent Fernando Haddad. Bolsonaro benefited from a surge in the polls from a sympathy vote, after he was left unable to campaign following a stabbing attack. His opponent made the mistake of focusing on the strong support base of former President Lula, in the poverty-stricken North-East. Meanwhile the majority of voters rejected Lula’s PT party which they associated with corruption and economic incompetence. The swing behind Bolsonaro was quite remarkable, reflecting a revulsion against crime and corruption. This also propelled his PSL party to the second largest in the lower house. Fears that a Bolsonaro-led government would trample over human rights was allayed by the appointment, to the Justice Ministry, of Sergio Moro, the highly respected judge who pursued the Lava Jato corruption investigation. The Finance/Economics ministries will likely be run by free-marketeer Paulo Guedes, who has a PhD from Chicago and founded investment bank BTG Pactual. He has publicly prioritised social security reform and privatisationdriven debt reduction. Both will be good for Brazilian spreads, assuming the other factions within the Bolsonaro camp can be persuaded to spend political capital on this agenda in a very fragmented Congress.

The Mexican peso plunged by 8% in October after president-elect Andres Manuel Lopez Obrador “AMLO” held a “consultation” on a half-built new airport project, and then announced that he would implement a 70% majority outcome in favour of scrapping the project. Only 1.07m people voted in the “consultation”, out of a population of 129 million. The project is already more than 30% complete, been funded by the private sector and the alternative, to expand a nearby military airbase, has been criticised as unfeasible. Investors are concerned that the modus operandi of using undemocratic “consultations” as political cover for taking populist decisions will add to uncertainty regarding private sector investment in Mexico. One potentially concerning area for populist policies is in the energy sector, where AMLO wants to use Pemex to build refineries despite the very heavy debt load of that company. The many foreign holders of peso-denominated bonds are becoming concerned that AMLO’s policies could lead to higher inflation in the longer run, hence 10-year peso yields had a brutal 90bps sell-off over the month.

EMBI spread and yield

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

In Sri Lanka, President Sirisena threw the country into a constitutional crisis when he fired Prime Minister Ranil
Wickremesinghe and suspended parliament for two weeks. Ex-President, Mahinda Rajapaksa, was put forward by the President as a replacement. Whether this move was constitutional is being questioned, as the normal procedure to change a sitting government is through a vote of no-confidence, which did not take place. It is also unclear whether Rajapaksa can command sufficient support in the parliament to form a government, as his party appears to only have 95 out of 225 seats. Ex-President Rajapaksa performed very well in local elections earlier this year and his presidency was characterised by large infrastructure projects, funded by Beijing, but he also co-operated with the IMF. With significant debt repayments due next year, as well as the end of the IMF program, the political uncertainty led bond spreads to widen 171bps from trough to peak.
 

Which were the best performing countries in October?

The best performers in the month of October were Lebanon (+3.05%), Brazil (+2.01%) and Suriname (+0.76%). The worst performing countries were Sri Lanka (-7.27%), Venezuela (-6.32%) and Senegal (-5.96%).

Country returns (Top and bottom 10)

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

Market outlook

EM growth and exports should continue to benefit from slow but steady growth in developed countries and expanding world trade volumes, although at some point we expect the US economy could decelerate to a slower pace as monetary tightening takes hold. Subdued underlying money and credit growth in many EM countries means that inflationary pressures from recent currency devaluations should be temporary, and most central
banks can afford to let floating currencies act as an adjustment mechanism. Most countries with current account deficits have tightened policies, which should help foreign reserves to stabilise going forward.

Sanctions against Iran should bolster crude oil prices, and it seems that “OPEC+” has a reduced ability to fully plug the resulting supply shortfall, thus underpinning energy prices. In China, the policy of “regulatory tightening” has been replaced by a more aggressive “monetary loosening” along with fiscal measures to boost consumption and support private companies facing difficulties from the impact of the trade war. Infrastructure investment is still languishing. The US “trade war” with China will most likely continue, and even escalate next year we believe. This scenario is now more fully priced-in to markets, and participants are watching closely for evidence of an impact on growth and/or inflation. As the recent deal with Mexico and Canada shows, benign outcomes are still possible under the Trump presidency.

The Fed’s balance sheet is now shrinking by more than $30bn per month, and the European Central Bank’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 EM debt from a technical perspective. Going forward, any further pick-up in global market volatility and/or a US slowdown could be met by a dovish tilt from the Fed that would support EM assets. EM sovereign issuance has already reached $132bn year-todate, 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 360bps is wide to the post-Lehman’s average, so valuations are attractive.

We see three main risks to the outlook. Unexpectedly strong price or wage inflation data in the US could accelerate Fed 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 Renminbi, 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.