Bonds & Loans: What is your baseline expectation for the global economic environment?
Kaan Nazli: So far, we have seen a fairly US-centric economic recovery. Europe has performed poorly and growth across EM has slowed, in line with weakening export demand due to the slowdown in China.
As it stands, we are forecasting a slowdown in the US during 2H, which means that we will need to see some pickup in Europe and China to provide a boost to EM. There has been some slowdown in the US, though this hasn’t been as fast as expected. Trade tensions are fairly acute, which has impacted Europe and China in particular.
Kaan Nazli will be attending this year’s Bonds, Loans & Sukuk Turkey conference (Wednesday 13th November, Shangri La, Istanbul) where he will be speaking on the following topic: Understanding the current credit market in light of a changing economy: How are investors pricing Turkish bonds?
Central Banks are in panic mode. We expected more Fed hikes this year, but instead rates have been cut, and I don’t think this will be the last one. So, we’ve arrived at a situation where we’ve seen continued noise on the trade side, which is a significant downside for the global economy; on the other hand we’re seeing a lot of support from central banks — which we were not expecting to see, so all in all, it’s a pretty confusing economic environment.
It looks like the trade war is escalating to a currency war as well. We’ve also seen three Asian central banks announce cuts – New Zealand, Thailand and Singapore. The response from the US was as expected: Trump wants to cut rates, weaken the dollar, and end quantitative tightening.
As such, from an EM perspective, we are in a weak growth, high-uncertainty environment.
Bonds & Loans: How is bond supply likely to evolve over the coming months? Where are you seeing the best opportunities in EM at the moment?
Kaan Nazli: We’ve seen a significant amount of issuance throughout 1H. Typically, by the end of July we have seen around 60% of each year’s issuance. Looking forward to the next four to five months, we are likely to see substantial investment grade issuance, potentially from the Gulf, Poland and other Eastern European countries, as well as Colombia. Ongoing trade tensions may put a cap on further issuance from frontier and high yield names. We’ve already seen some high-yield credits come to market – and we may see Angola, and even Egypt return. At the moment we’re expecting around USD30bn of additional issuances before the end of the year, of which we expect USD20bn will be investment grade.
We tend to prefer EMEA because they don’t tend to have the same degree of exposure to China that Latin American or Asian countries have. As such, we tend to have a more cautious stance on Asian currencies. In terms of the hard currency sovereigns, Argentina is currently undergoing an IMF programme, and with very high spreads, they aren’t able to issue. This has been another factor keeping net issuance from EM low.
But we maintain a constructive approach on the country even though the primary result has increased risks. When we look at different scenarios - even a populist government doesn’t look as bad as we thought six months ago. The grim state of the economy means that whoever wins will likely be forced to pragmatic policies. Even a Fernandez victory, for example, may not shut down relations with the IMF, so the tail risks have been trimmed somewhat.
We also like Ukraine. Generally, our positioning has been higher-yielding credits such as Ukraine and also the frontier space.
In terms of local bonds, we think the current market environment works in their favour. This is particularly true of Asia as continued trade tensions are likely to see further easing – as demonstrated by recent cuts.
Bonds & Loans: Is the current FX outlook in Turkey influencing your approach to investing in local currency markets?
Kaan Nazli: Turkey has been a wild card. It has been a very well performing local market and the currency has remained quite strong recently. There was a lot of geopolitical risk priced into the currency. There was concern that we could potentially see sanctions from the US, but now we feel that geopolitical risk has been priced out.
This doesn’t make us completely comfortable. Whilst Argentina has pursued fairly orthodox policies under Macri in response to its crisis, Turkey cannot give up on growth – the government is constantly trying to stimulate the economy. As long as the global environment is supportive, they will be able to do that, but if there is a sudden halt in capital flows, Turkey will be even more exposed than Argentina, and they don’t have the same support from the IMF. But they’re doing very well – the lira has been acting like the Swiss franc or the Japanese yen for the past few weeks – it’s been very strong. But I wouldn’t be surprised if it takes a hit in the event that we see a surprise data point on FX reserves or public debt.
Bonds & Loans: Argentina and Turkey have often acted as bellwethers in terms of signalling sentiment towards EM. Do you expect them to maintain this status going forward?
Kaan Nazli: Among major EM countries, they stand out in that sense. In Turkey, it is the private sector that holds lots of debt; in Argentina it is the public sector. In both cases, there is significant dollar borrowing. Argentina often grabs the headlines at the moment though looking at the country’s relative share in global trade and finance it is not a systemic risk.
Bonds & Loans: The European Investment Bank recently announced that it was going to halt all government-linked investment in Turkey until the end of this year. Has this changed your perception of Turkey and to what extent?
Kaan Nazli: It certainly doesn’t help. The EIB is the type of creditor that you don’t want to lose in the current global environment. The projects the EIB are involved in are longer term, and typically more infrastructure related and value adding. It will certainly hurt foreign perception of Turkey. Nevertheless, Turkey is a big borrower – their overall external debt is USD440bn – and the EIB’s overall contribution is very small – less than 1% so they are easily able to find alternative sources of financing from the private sector.
In terms of where Turkey can look for alternative financing, we think it will be substituted by private sector sources, likely from European private banks that already have established relationships.
Bonds & Loans: How well is Turkey prepared for the next downturn?
Kaan Nazli: In some ways it is better prepared than before. A year ago, the current account deficit peaked at USD58bn for a 12-month period; now it sits at USD5bn. This is certainly helping reduce FX demand in the economy, which – combined with seasonal factors such as tourism - helps explain why the currency has done so well over the summer.
The risk is that public debt and the fiscal deficit have grown. In Turkey there was always confidence that the public sector is healthy, and that this could provide a potential backstop for the private sector. Now, with the deficit deteriorating, the private sector needs more FX, but the public sector is not able to help. So I do think there is a lot of vulnerability for the next downturn. We are looking at negative 1% to -2% GDP growth this year, and we are forecasting a swing back to positive growth next year. But a year of economic contraction will put pressure on the economy, and external ratios will be strained.
Bonds & Loans: Exceedingly and persistently low – or negative – yields across developed markets are driving capital into more exotic destinations and credits. What are main risks to investors in this ‘new normal’ where credits of varying quality and opacity are squeezed to historically low yields?
Kaan Nazli: The biggest risk to investors is commodities. Much of Africa, but also countries such as Mongolia, are very exposed to commodity price swings. China, historically one of the biggest importers of commodities, is already in the process of moving away from being a more investment driven to more consumption driven economy. This is already affecting demand for commodities.
The second risk is that debt levels are going up. Every debt report shows that frontier market debt is on the up. It’s at a point where you need to make choices between more risky economies and those that are on a reform path.
That said, we like Ivory Coast – they have a former IMF official as President, for instance. They had a dual shock in 2017, with a series of mutinies in the army that reminded people of the civil war in 2010. The price of coca crashed, which was particularly tough given that they make up around 30% of global supply. Following this, they entered an IMF programme fairly quickly. They came to the bond market, and within two or three years the deficit returned to normal levels. Whenever they funded externally, they made sure to fund less internally. With that type of name, we feel there is credibility, and we are confident that they will make the right decisions to cope with external shocks.
In Zambia, for instance, we’ve seen a different approach. The country has borrowed heavily externally, and now has around a 90% debt-to-GDP. In the Ivory Coast, we’re looking at 40%. The spreads are higher in Zambia, but we remain focussed on the risk-adjusted-return.
Bonds & Loans: In the medium-term it now looks like the ECB and the Fed are going to continue their current easing cycle. But in spite of this, we are already seeing some signs of a potential recession with the US and Germany. What do you think the solution will be if a downturn does come and we remain at near-zero rates?
Kaan Nazli: This question is constantly in our minds as well. We already thought that the yields on Treasury Bills were too low, and if anything, they have gone even lower. If everyone is cutting then it becomes pointless in a way. In the next few months, I think the direction will be lower rates, and it will never go as far as the market suggests. A year ago, we were looking at significant hikes in rates, and that has reversed significantly. I don’t think it will be as deep a recession as the one we saw after the financial crisis. Going forward, it very much depends on how the US-China relationship shapes up and how the US election results go as well.
Bonds & Loans: With a likely downturn looming, how are investors positioning themselves in response?
Kaan Nazli: More and more houses are revising down their treasury and bunds yield forecasts, as fixed income is one of the areas that typically receives a lot of support in the current environment. On the other hand, there is a significant amount of negative-yielding debt right now, which inevitably pushes funds into higher yielding products such as emerging and frontier markets.