PRESSURE ON EM DEBT HAS INCREASED, BUT FUNDAMENTALS REMAIN SOUND
In line with the expectations we outlined in our Q3 2018 EMD Quarterly Outlook paper “Mind the Valuation”, volatility has continued unabated in emerging markets and performance divergence between fundamentally weak and strong names has been remarkably high. We saw a number of factors—such as trade wars, policy mismanagement, geopolitics, growth momentum and technicals— that helped fuel this differentiation. As most of these factors are still playing out, we anticipate further bouts of volatility as the emerging markets continue to go through a number of structural and idiosyncratic challenges.
The correction that began in mid-April of this year continued, briefly challenged by a mid-summer reversal during which all EM debt sub-asset classes posted positive returns. However, this relief rally was short-lived as idiosyncratic stories and contagion to other weaker borrowers again saw EM indices drop into the red. We expect this scenario of range trading with temporary relief rallies and ensuing corrections to continue repeating itself in the upcoming months. As a result, the September short- squeeze, during which EM investors trimmed their underweights in EM underperformers, does not yet to appear to represent a prudent time to add significant risk. However, this does not imply that we are negative on the asset class. Instead, we argue that tactically capitalising on bouts of weakness and mispricing is the appropriate strategy in this environment.
Local-currency bonds delivered a negative return of -3.60% (in USD) in Q3 2018, while hard-currency corporates and sovereigns delivered a more marginal performance (Exhibit 1). Turkey and Argentina accounted for the bulk of August’s underperformance. Both have seen their local currencies depreciate dramatically:
-24.9% and -25.6% against the US dollar in August, respectively. While the underperformance in Turkish assets has been largely self-inflicted through unorthodox policies and lost credibility, the textbook response from Argentina’s policymakers has failed to meaningfully alleviate the pain. Although the contagion to the rest of emerging markets so far looks negligible and is mostly felt through flows as confidence was shaken, such underperformance of the most externally vulnerable EM countries raises the question of whether other fundamentally weaker countries will follow suit.
Hard-currency bonds marginally underperformed their local-currency counterparts
EXHIBIT 1: PERFORMANCE SUMMARY – 3 MONTHS TO 28 SEPTEMBER 2018
Source: Bloomberg, J.P. Morgan Asset Management. Indices do not include fees or operating expenses and are not available for actual investment. EM = Emerging Markets; DM = Developed Markets; IG = Investment Grade; HY = High Yield; UST = US Treasury; EM Hard Currency Sovereign = JP Morgan EMBI Global Diversified; EM Local = JP Morgan GBI EM Global Diversified; FX = Foreign Exchange; US High Yield = JP Morgan Domestic High Yield; US HG = JP Morgan JULIR ex-EM; Commodities = Bloomberg Commodities Total Return; EM Equities = MSCI-EM; data as at 1 October 2018. Past performance is not a reliable indicator of current and future results.
EM GROWTH MAY SLOW, BUT WE DO NOT EXPECT A DISORDERLY MARKET
Investors appeared disappointed by EM GDP data for Q2 2018. While we saw better growth numbers in a number of countries, such as India or in the Andeans, economic shocks in Turkey and Argentina, slower growth in China and other EM countries have all weighed on EM growth, leading us to expect slower growth of 4.6% in the full year of 2018. Our growth projection for this year and the next (4.4%) appears more pessimistic than the expectations of the rest of the market. It is important to note, though, that we expect a slowdown and not a systemic crisis— and that emerging markets will continue to grow at above-trend levels during these periods.
In contrast to emerging markets in the second quarter, developed market (DM) growth has picked up, led by stellar data in the US. This generated additional pressures on EM countries during the second and third quarters. We anticipate that DM growth will remain elevated in the rest of 2018, especially as the effects of the fiscal stimulus in US have yet to fully crystallise.
We expect EM—DM growth alpha to fall to around 2.3% in 2018, with a slight recovery likely in 2019 (Exhibit 2). A prolonged period of above-trend DM growth might accentuate a period of weaker EM growth in the eyes of investors. Rising US Treasury yields and the US dollar would likely exert continued pressure on EM countries through various channels, including EM foreign exchange (EMFX), liquidity, refinancing costs and capital flows. EM economies with high external financing needs and weaker fundamentals remain particularly susceptible as a shutdown in capital flows will hurt these countries the most.
EM-DM growth alpha should fall to around 2.3% 2018 before recovering slightly in 2019
EXHIBIT 2: GDP GROWTH (% YOY) IN EMERGING & DEVELOPED MARKETS
Source: Bloomberg, J.P. Morgan Asset Management, National Sources, Haver Analytics, International Monetary Fund (IMF); data as at 14 September 2018. Data for 2Q 2018 for EM/DM aggregates include some estimates. Forecasts for regional aggregates are from JPMorgan. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
An appropriate policy response from EM central banks in this environment will be crucial. Many find themselves in a challenging environment as considerable EMFX depreciation against the US dollar imports domestic inflation, but monetary policy response will also be limited due to closing output gaps and signs of overheating in some EM economies, particularly in CEE. What’s more, oil prices are at multi-year highs in US dollar terms, and are even more expensive when converted to local EM currencies. As a result, most EM central banks have already turned more hawkish in the past few months (Exhibit 3).
Most EM central banks have already turned hawkish
EXHIBIT 3: EM CENTRAL BANK POLICY ACTIONS
Source: Bloomberg, J.P. Morgan Asset Management, National Sources, Haver Analytics, International Monetary Fund (IMF); data as at 4 September 2018. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. E = Estimate, F = Forecast.
CHINA IS ON COURSE, BUT DOWNSIDE RISKS ARE INCREASING
China continued with its efforts to tame the shadow banking system and reduce corporate leverage so far this year. However, financial deleveraging and weakening industrial sales have started to hurt the private sector more than anticipated, causing a significant spread widening in the corporate space. Although spreads have compressed since then due to a significant policy response, we anticipate China’s State-owned enterprise reforms will persist, with more consolidation and more shutdowns of inefficient enterprises. This, along with escalating trade wars, continues to pose a downside risk in China. As a result, we increased the probability of a deterioration scenario in China for the next 12 months (See Exhibit 4).
Growing trade war tensions have reached new heights over the past quarter and in our base case scenario we see further gradual escalation and retaliation during the rest of the year. The impact from trade should be relatively limited this year, amounting to around 0.2% knock-off from the annualised fourth-quarter GDP growth number. However, if no mutual solution is found, this impact will increasingly weigh on China’s economy. Our forecast is that China will grow at 6.5% in the Q4 2018 and at 6.2% in 2019, which is marginally below market consensus.
On the positive side, policymakers have been ramping up policy easing measures to partially negate the damage from trade wars and ongoing financial deleveraging. In addition to the announced counter-cyclical measures such as spending increases in local government infrastructure projects and tax changes to boost consumption, there is still room for further fiscal and monetary stimulus. However, we don’t anticipate anything as radical as the economic stimulus programme implemented in 2008—2009.
An increased chance of a deterioration scenario in China for the next 12 months
EXHIBIT 4: CHINA SCENARIOS (12-MONTH OUTLOOK)
Source: J.P. Morgan Asset Management; data as at September 2018. *Reflects change from previous quarterly outlook.
ADDRESSING THE IMBALANCES
Over the past six months, the macro environment for EM debt has faced mounting challenges. In addition to the domestic political and idiosyncratic risks in most of the large EM countries, rising core rates and strengthening US dollar have added to the pressures. To further complicate matters, escalating trade wars have amplified the uncertainties over emerging markets.
However, one thing remains unchanged in the emerging markets: stronger underlying fundamentals that have improved significantly in most countries and corporates since the Taper Tantrum. The aggregate current account deficit (Exhibit 5A) has turned around in recent years and, together with more adequate FX reserve ratios (Exhibit 5B), offers emerging markets more protection against external shocks.
Current account deficits have turned around and FX has adjusted
EXHIBIT 5A: EM CURRENT ACCOUNT DEFICITS
FX reserve ratios are more adequate than in previous crises
EXHIBIT 5B: EM RESERVES TO IMF RESERVE ADEQUACY RATIOS
Source: IMF, J.P. Morgan Asset Management; data as at 4 September 2018. *IMF adequacy metric: a. Fixed: Exports (10%) + Broad Money (10%) + ST Debt (30%) + Other liabilities (20%); b. Floating: Exports (5%) + Broad Money (5%) + ST Debt (30%) + Other liabilities (15%). Previous crises = average of Asian Financial Crisis 1997, Global Financial Crisis 2008, Taper Tantrum 2013. /1 Using fixed exchange rate adequacy metric. REER = real effective exchange rate; CAB = Current account balance; LHS = Left-hand scale, RHS = Right-hand scale; EM = emerging markets.
This year has largely confirmed this trend as strong investment- grade countries remained little affected, while countries such as Argentina and Turkey, which failed to make these adjustments, have seen rapid deterioration in macro data and bond prices.
Improvements from emerging markets’ position in previous crises can also be seen in other data such as aggregate private sector debt (Exhibit 6) and Bank of International Settlements (BIS) Credit Gaps (Exhibit 7), both of which are indicating a tangible turnaround over the past several years.
Looking from the bottom up, the picture also looks positive: EM corporate fundamentals are on a strong footing. Although aggregate Earnings before interest, tax, depreciation and amortisation growth looks to have peaked at around 11% year on year, this still represents a huge tailwind for EM corporate balance sheets as capital expenditures and outstanding debt stock remain cautious.
A more positive picture on private sector debt
EXHIBIT 6: EM PRIVATE SECTOR DEBT (% GDP)
Source: Institute of International Finance (IIF), J.P. Morgan Asset Management; data as at 9 July 2018.
Credit gaps point to a tangible turnaround in recent years
EXHIBIT 7: BIS CREDIT GAPS (% GDP)
Source: Institute of International Finance (IIF), J.P. Morgan Asset Management; data as at 7 September 2018. /1 BIS credit gap: difference between total private sector credit-to-GDP ratio and its long-run trend.
It’s reasonable to expect that some of the positive fundamentals mentioned here may weaken due to the less favourable macro backdrop and idiosyncratic risks in individual EM countries. We anticipate that escalating trade war between the US and China is likely to put further pressure on China’s current account balance and weigh on the Chinese yuan, erasing some of the currency reserves in the process. EM corporate EBIDTA growth will likely fall, together with weaker GDP growth and consumption data.
While commodity exporters and manufacturers with current account surpluses should remain resilient, weaker countries that fail to make adequate policy adjustments will continue to suffer. Monitoring these fiscal and monetary responses will be key, but emerging markets on aggregate are still looking healthy.
SHORT-TERM PAIN IS STILL ON THE CARDS FOR TECHNICALS?
A poor year for EM debt has resulted in low issuance in hard- currency corporates and sovereigns. This was not solely driven by summer liquidity, but rather by a challenging environment and lacklustre investor demand. For hard-currency sovereigns, we have revised down our gross issuance forecast to around USD 130 billion, compared to USD 167 billion in 2017. Similarly, in EM hard-currency corporates, gross issuance this year should fall short of our earlier forecast of around USD 440 billion, but we do expect supply from China and Middle East to remain significant in the upcoming months as the market stabilises slightly.
Positioning and flows to our asset class remain essential to monitor. The common belief is that the negative fund flows over the past half a year have resulted in less crowded positioning in emerging markets. However, the aggregated amount of outflows does not look that large compared to the huge cumulative inflows the asset class enjoyed in 2016 and 2017 (Exhibit 8).
Also, looking at peer fund beta that out in-house quantitative team tracks, many peer investment funds look to be already positioned long risk despite the more volatile backdrop. Although we believe that much of the non-dedicated money has already left our market and remaining investors are focused more on the long-term, there is still a risk of another wave of outflows in the event of further headline noise and volatility.
EM debt sectors enjoyed huge cumulative inflows in 2016 and 2017
EXHIBIT 8: CUMULATIVE INFLOWS TO MAIN EM DEBT SECTORS SINCE 2012 (USD BN)
Source: J.P. Morgan Asset Management, Applied Research Group, Bloomberg; data as at 17 September 2018.
WHERE IS THE VALUE?
As in any period of volatility, the past few months have created some interesting opportunities in our market. One particular trend has been obvious: the market’s appetite for simple yield gave way to a more nuanced focus on sustainable fundamentals. This has been especially evident in the hard-currency corporate space, where valuations are at historical tights for investment- grade bonds, but BB and especially B rated corporates are trading closer or even wider to five-year averages (Exhibit 9).
In many ways, this makes sense as weaker credits are more susceptible to tighter global financial conditions and slowing EM growth in this stage of the EM cycle. However, such pronounced spread-widening came as a surprise given the strength of corporate fundamentals, especially in credits such as Argentina’s YPF, Pampa Energía or Brazil’s JSL that we flagged for their relative fundamental strength to valuations.
Index spread widening driven by weaker credit stories
EXHIBIT 9: CEMBI BD SPREAD VS. 5-YEAR AVERAGES
Source: J.P. Morgan Asset Management, Bloomberg; data as at 12 September 2018. CEMBIBD - JPMorgan CEMBI Broad Diversified Index.
In the hard-currency sovereign space, the situation is similar, with the bulk of the spread widening driven by high-yield underperformance, while investment-grade sovereigns have seen little spread widening when compared to US investment- grade corporates (Exhibit 10A). It’s also important to note that even after excluding Venezuela, Argentina and Turkey from the index, the high-yield sub-index trades close to all-time wides vs. US high-yield corporates, suggesting that it wasn’t just the volatile idiosyncratic stories that drove the negative returns this year (Exhibit 10B). However, the decoupling valuations between EM high-yield sovereigns and US high-yield corporates suggests that the EM high-yield sell-off wasn’t just driven by higher external financing costs and tighter financials conditions as these factors would have had a lasting impact on DM valuations as well. Instead, it suggests a more negative outlook on EM growth, country-specific stories and other fundamental trends in emerging markets.
Little spread widening in investment-grade sovereigns vs. US investment-grade corporates
EXHIBIT 10A: EMBIGD IG SPREAD TO US IG
The high-yield sub-index is trading close to all-time wides vs. US high-yield corporates
EXHIBIT 10B: EMBIGD HY EXCLUDING VENEZUELA, TURKEY AND ARGENTINA SPREAD TO US HY
Source: J.P. Morgan Asset Management, Bloomberg; data as at 12 September 2018. EMBIGD = JPMorgan EMBI Global Diversified Index; US HY = JP Morgan Domestic High Yield; US IG = US HG = JP Morgan JULI ex-EM.
EM local currency returns are known for their volatility, and this year has again reaffirmed this reputation. At the beginning of September, the JPMorgan GBI-EM Global Diversified Index reached a drawdown of around -16.4% in US dollar terms. The Argentine peso and Turkish lira have depreciated against the US dollar by 54.9% and 37.3% during the nine months this year.
Most other high-beta EM currencies have also done poorly, albeit to a lesser extent. The Mexican peso was the outlier this year, managing to actually appreciate against the US dollar as presidential elections failed to bring unwanted surprises and the NAFTA agreement appears to have been finalised. On the aggregate level, EMFX valuations are now close to the lows last seen in early 2016 (Exhibit 11). Local rates, especially the high- yield sub-index, continue to offer significantly positive real yields, but the risks of an EM inflation pick-up and more hawkish central banks make valuations look less attractive.
EMFX valuations are now close to the lows last seen in early 2016
EXHIBIT 11: EMFX REAL EFFECTIVE EXCHANGE RATES (REBASED TO LONG-TERM MEDIAN*)
Source: J.P. Morgan Asset Management, Bloomberg; data as at 30 August 2018.
*Long-term median based on data since Jan-95. EM FX = JPM GBI-EM Global Diversified Index member countries. EM high yielders = Argentina, Brazil, Indonesia, Russia.
ROADMAP AND THEMES
Our strategy roadmap for Q42018 (Exhibit 12) has not changed materially since the last quarter. Our base-case “reflation” scenario remains intact, with the same 50% probability as in the last quarter.
Gradual reflation scenario remains our base case for Q4
EXHIBIT 12: Q4 STRATEGY ROADMAP
Source: J.P. Morgan Asset Management.
Instead, we marginally reassessed our tail scenarios, assigning a higher probability of 25% to the “growth shock” scenario. This shift was based on higher imbalances in global growth stemming from tighter financial conditions, growth de-synchronisation in developed markets, escalating trade wars, a slowing China, lower global trade and late-cycle signs in developed markets. In line with this, we have decreased from 30% to 25% the probability of the “acceleration” scenario, in which global growth accelerates as the US continues to grow at a strong pace, supported by pro-growth US policies such as the US fiscal stimulus.
In our base-case scenario, global growth remains above the long-term average, led by the US. Due to tighter financial conditions, idiosyncratic risks and trade wars, we expect EM growth to slow in the upcoming quarters, with the EM— developed markets growth alpha narrowing. However, even with slower EM growth, inflationary pressures in emerging markets will remain, especially if EMFX fails to rebound and oil prices remain elevated. This, together with rising core rates, will put the EM central banks into more hawkish territory, leading to more interest rate hikes and less room for monetary easing.
Countries with higher external vulnerabilities will have to be more cautious and adjust their monetary policies more boldly, while also not overly depressing domestic growth.
In terms of strategy, we look to be more tactical on risk in the upcoming quarter. We see little room for spread tightening given the less favourable macro backdrop and valuations that don’t necessarily reflect some of the tail risks. As fundamentals remain broadly on a strong footing, especially in the corporate space, we aim to use moments of market weakness and target names that have been unfairly punished in recent months.
We believe that technicals in the near term may pose downside risks as investors shy away from an asset class overshadowed by idiosyncratic headline risks. Although a significant amount of cross-over investors have withdrawn their allocations from EM debt, further outflows and the long-risk positioning of a number of dedicated funds doesn’t bode well for the risk environment in the short term.
Although valuations adjusted primarily in the lower-quality credit space, we favour higher-quality names as we avoid value traps in fundamentally weaker names that are likely to see further deterioration. We aim to be positioned short duration across strategies as we expect core rates to gradually rise. We have no clear preference between EM sovereigns and corporates as our positioning is likely to be driven by tactical and liquidity considerations. Local rates are likely to come under further pressure as EM central banks err on the hawkish side, but EMFX offers both—attractive absolute valuations and interesting relative value opportunities.