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Off the Record: Global Investors On Concerns and Opportunities in Emerging Market Debt

The rally in EM assets this year seems all but unstoppable as investors continue hunting for yield further afield amidst persistently low interest rates in developed markets and a weakened US dollar. Is it set to continue? Bonds and Loans speaks with global investors one-on-one about macro trends influencing EM debt capital markets.

Aug 8, 2017 // 4:18PM

According to data from the Institute of International Finance (IIF), non-resident capital inflows to emerging markets should reach US$970bn this year, a 35% increase from 2016.

Demand for EM assets seems insatiable despite lingering concerns of overheating: just this week EM bond funds registered US$1.9bn in capital commitments, according to flows tracked by EPFR.

However not all EM countries inspire the same degree of excitement from global investors. To understand how investors are digesting the market, Bond & Loans held one-on-one meetings with global investors in London and discussed some of the trends they are observing.

The general consensus was that, in a low-rate environment, investors will continue expanding EM asset purchases, a sign of their growing dependence on EM assets to guarantee higher returns in their portfolios. Investors that have historically underweighted in EM are now looking to increase their exposure to emerging market debt, despite the fact that it is no longer the cheapest asset class in the market.

In general terms, steady economic growth rates and falling inflation are a recurring motif throughout many emerging economies. One threat that has been discussed at length in the past is the eventual unwinding of QE in developed markets, particularly in Europe. While it will inevitably impact EM debt, investors are not particularly concerned as this process will likely take years, if not decades, to play out. Ultimately, the biggest concern is Western institutional investors potentially losing interest in EM debt. As these countries transform into more mature economies, investors will no longer be looking for impressive growth rates, but the deeper ‘quality’ of the growth. That said, emerging market economies need to continue along the reform path for their debt to remain attractive.

Breaking it Down by Country

The majority agreed that both Brazil and Russia represent the best opportunities at the moment, both in terms of hard and local currency debt; China is still on everyone’s mind, even if they see it through more rose-tinted lenses; and, Turkey and Venezuela present the biggest concerns. Nevertheless, nuances across the EM landscape persist.

Brazil: Appetite for Brazilian debt, particularly local currency debt, is extremely high as the real has performed very well against the US dollar, rising 6.7% in the last month. As the government continues to reign in inflation and put Latin America’s largest economy on the path of economic growth, investors remain bullish. They warned that the country’s sustained positive performance will depend on the ability of the government to enact structural reforms, especially labour law reform. Political risk is no longer a significant concern, particularly after the vote of confidence Temer received recently in the courts. Some asset managers point out that other Latin American and EM markets hardly moved as the Brazil scandals began to emerge – another sign of EM stability. These markets are obviously less susceptible to “sell-off infestations” that were so common in past decades.

Russia: Despite the fresh US sanctions investors continue to view Russian debt as a good deal. That’s mostly due to the high quality of its financial institutions and the strong mandate of the Central Bank. The rouble’s depreciation has reversed, oil prices have recovered and agriculture has benefitted from EU counter-sanctions. That said, no major shocks can be expected for Russia in the foreseeable future. However, it is unlikely the country will return to it is golden years (5-10 years ago) if it does not transition away from being a commodity-driven economy.

Argentina: To Latin America-focussed investors, Argentina’s sovereign and corporate securities are still appealing. As the former market pariah came storming back onto the global scene two years ago, bond holders can’t get enough of Argentina’s debt, both in hard and local currency. Investors have confidence in the progress made on the reform front, led by the centre-right president Mauricio Macri.  Investors believe growth will return, while inflation and nominal and real rates will come down. Once the mid-term elections in October pass, we will have a clearer view on the medium to long-term outlook.  Investors forecasts on growth seem to be in line with those of the IMF and OECD, which estimate Argentina will grow 2.4% in 2017.

China: Investors agree that China remains the key player in the EM universe, but as some are inclined to look at the Asian giant with persistent concern, others believe that the worst has already passed. One investor explained that that Chinese government has been able to stabilize its economy, and while some marginal reforms are still needed, China is well on the way to transforming from a manufacturing-led economy to one focused on services. Some pointed to huge offshore demand on Chinese debt, primarily RegS deals, meaning that issuers are targeting a much wider investor universe, not just US investors as before. Generally, China and the Middle East are seen to be much less reliant on Western capital now.

Peru: For investors, Peru remains a “safe choice,” even if the economy has slowed down in recent months, due to ongoing corruption scandals and natural disasters. They agree that Peru is a well-managed country with orthodox economic policies and will remain so in the near future.

Colombia: There is a divergence of opinions regarding Colombia. Some are sceptical of Bogota’s commitment to its relatively austere fiscal strategy; others believe the country shouldn’t struggle in this regard. Either way, its key challenge will be how to address its fiscal deficit, particularly if it wishes to avoid a credit downgrade.

Turkey: Political conflict and a societal sense of unease in the country is overshadowing an “okay” economic performance. Even with inflation coming down and stable growth, internal polarization could eventually reprice Turkish securities.

Venezuela: It is no longer a case of ‘if’ the country is going to default, but ‘when’. Investors that stick with Venezuela are betting on different political outcomes, but in the long-term Venezuela is doomed. Most agreed that Venezuelan debt, while currently cheap and high-yielding, is likely to encounter a significant repricing, if not this year then 2018.

Qatar: Qatar still cultivates the perception of a high-quality, high-return credit, despite the sanctions imposed on it by its GCC neighbours. While there’s a general consensus that the current conflict will not escalate to a full-blown war, a quick diplomatic resolution is not on the horizon; that is bound to put a dent in the sovereign’s economy. But, the boycotting GCC states, incidentally, also suffer in terms of rising yields and proliferating risks.

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