Henderson - EM's Diverging Universe
2015 is definitely not the year to be making general statements about emerging markets (EM).
2015 is definitely not the year to be making general statements about emerging markets (EM). The EM asset class is made up of a diverse mix of credits with varying risk and reward prospects, and the fortunes of the various economies within EM are currently increasingly diverging. There is a particular contrast between commodity exporting and commodity importing countries. Additionally in emerging Asia, there are different dynamics between commodity importers and manufacturers. The shifting dynamics make active management and fundamental research particularly important. For the selective strategy, EM credit currently offers a compelling investment case with certain countries attractive on valuation and fundamental grounds, others presenting tactical opportunities, while some markets are best avoided.
A high level look across the EM universe demonstrates the dynamics currently at work:
Asia is changing. Asian countries are increasingly becoming consumption-driven, shifting from their manufacturing-dominated economic status of the past; innovations in e-commerce are driving growth while demographics silently act as a further catalyst. The trends, while well-rehearsed, are ever important and are set to continue for a number of years. Meanwhile lower oil and commodity prices will work to the benefit of importing countries, such as India and China. The strong reform agenda pursued by India strengthens the country’s prospects while China is slowly becoming increasingly consumer-driven.
Latin American economies are on a different path; their pace of growth has now generally slowed and will likely continue at sub-par levels. Hurt by weakening commodity prices and the strength of the US dollar, their depreciating currencies present challenges. Additionally, the desire to raise interest rates to control inflation is a dilemma for many given the need to simultaneously stimulate growth.
Elsewhere, growth is weakening in Central and Eastern Europe, despite some signs of resilience in domestic demand. With Russia in recession and likely to remain there at least for the next two years, countries with currencies directly linked to the euro will continue to suffer but will have some insulation with the support of the European Central Bank’s quantitative easing programme.
Technical and fundamental support
While certain macro and geopolitical risks remain, there is currently strong support for a constructive stance on EM.
Technical factors are positive
With government bond yields close to all-time lows and in some cases in negative territory, there is strengthening demand for corporate bonds (credit) and higher yielding assets around the globe. Chart 1 shows there are now close to €1.2tn of negative yielding assets globally and the levels of assets within various other sectors, including EM sub sectors. This implies a lengthy, more protracted multi-year environment of searching for yield and diversification, with EM a likely beneficiary.
Chart 1: Potential for asset reallocation into EM credit
Source: BAML, Bloomberg, Henderson Global Investors, as at 31 January 2015. Note: there may be overlaps within some sectors.
For investors seeking additional compensation, chart 2 shows the balance of risk and reward of moving down the credit spectrum, which markets can offer higher yields and how liquid those markets are. Each bubble represents the total volume of outstanding issues within the particular sector.
Notably, the US dollar-denominated EM corporate bond market has grown significantly in recent years and the depth that this provides makes an allocation to this asset class within a portfolio potentially attractive. While the demand continues, there will, of course, be intermittent periods of volatility in this extended credit cycle as more investors are crowded into the same markets. We believe it will therefore be increasingly important to have a sharp ‘credit picking’ focus with the current environment of more credit rating downgrades than upgrades in EM set to continue.
Chart 2: Sources of higher yield
Source: Bloomberg, Markit, RBS Credit Strategy, as at 7 January 2015. Note: Numbers in brackets signify amounts in €bn.
Supply and demand = supportive
The expected rise in demand for higher yielding assets corresponds with a time of reduced supplies in EM, with big issuing countries such as Russia and Brazil, finding it difficult to issue new debt. While investors shy away from Brazil on macroeconomic concerns, Russia faces a list of financial headaches. These include currency weakness and a looming recession as the country absorbs the double blow of Western sanctions over Ukraine and the sharp decline in the oil price since June 2014.
For euro investors there is, however, likely to be more euro-denominated issuance in EM credit, which should meet demand. On the flip-side, this would detract supply for dollar investors. A further supporting factor is the momentum gathering in the pace of inflows into EM external debt markets. This again is chasing a limited pool of securities relative to the scale of the demand and should therefore buoy prices.
Valuations favour EM
In many areas EM valuations are attractive relative to markets outside the sector. For example, on a 5-year historical basis, EM high yield credit is more attractively valued than US or European high yield.
Putting divergence to work
The current themes in our portfolio reflect the differentiation in EM and that we see this as a fundamentals-driven market. While headwinds remain at a macroeconomic level, fundamentals are improving for certain sectors and names. Careful selection between countries, sectors and stocks should therefore make a marked difference to overall returns.
The biggest overweight in the portfolio is China. This weighting is a result of credit specific opportunities, particularly within state-owned enterprises, infrastructure and quasi-sovereigns such as the ICBC, where we hold the subordinated additional tier 1 (AT1) perpetual bonds issued in October 2014.
Brazil/Mexico – macro challenges but credit specific opportunities
In Brazil there are a number of companies that are attractive from a valuation perspective. We have overweight positions in oil and gas and infrastructure (Petrobras and Odebrecht), and the ‘protein sector’ (meat and poultry). The latter is one of the biggest export markets for Brazil. In Mexico, the chemicals sector is attractive, although selectivity is required given the impact of overcrowding and valuations becoming rather rich.
Russia – look beyond the headlines
Russia is still interesting from a technical point of view and also on valuation grounds. However, we are highly selective in our approach. Favoured names include Gazprom, Lukoil and VimpelCom; the latter is a strong cash generative business, which is also buying back its bonds.
Markets currently to avoid
At the opposite end, there are areas that we do not favour on fundamental grounds (Argentina and Venezuela), while valuations elsewhere make investments unattractive at current levels. In Latin America these include Chile and Peru; in Asia, Thailand, Malaysia and Korea and finally in Europe, the Central and Eastern European countries.