Donald Trump is the best thing that has ever happened to emerging markets,” says one London-based EM fund manager. He is only half joking.
Low rates and quantitative easing throughout 2017 fuelled an extraordinary EM bond market. Strong inflows boosted returns, smoothed event risk, and enabled the likes of Tajikistan to make its bond market debut. Three US rate hikes were well flagged, and easily digested, allowing EM borrowers to continue to push the boundaries of investor appetite for lower rated debt and longer maturities.
In 2018, rates will undoubtedly rise but how investors will react to these rate hikes will be the crucial question for emerging market borrowers. Some investors are sanguine, and expect that the US Federal Reserve will have little cause to raise rates beyond the two hikes indicated by CME Group’s Federal Funds Futures tool. They are optimistic and expect business as usual. Others warn of capital flight risk, prohibitively expensive borrowing costs and negative returns.
Bryan Carter, head of emerging markets at BNP Paribas Asset Management, falls into the latter camp. Carter is positive on strong US growth, and believes that when the Fed says it will hike regularly, it will. In December the Fed pointed to three hikes in 2018.
“For 2018, we are expecting negative returns from duration, with the rise in interest rates causing investors to lose money in dollar bonds,” he says. “The negative returns will be fully offset by carry, but the total return for the JP Morgan EMBI Global will be 4% for 2018.”
By late November, Eurodollar interest rate futures were indicating a total of 57bp in hikes until December 2018. The market was pricing in one more rate hike for 2017, and expectations among the buy-side range from one to four hikes of 25bp over the course of 2018.
Disbelieving the Fed
Carter says some money managers distrust the Fed and its predictions. “Investors don’t want to believe it,” he says. “It’s part of a longer behavioural theme. We saw the same thing in 2004-2006. The yield curve refused to embed and the curve only just moved up before every hike.”
So long as what the market is pricing in is different from what the Fed is predicting there is potential for shock, says Paul Greer, head of emerging market bond trading at Fidelity.
“Both the Fed and economic data are suggesting more hikes than [what the market thinks],” he says. “If the Fed hikes more than what is priced in, which could happen if strong US data continues, that could have an impact on the front end of the curve.”
With US GDP growth figures above 3%, the expectation that Congress will introduce Trump’s far-reaching tax cuts, investment growth at 10%, wage growth and a pick-up in manufacturing, Carter believes that the US economy “hasn’t looked this good in years”. As such, the Fed has a pretty strong case to raise rates — and inflation, he adds, is picking up cyclically, with real inflation “higher than what is reported in the CPI”.
Carter does not believe that the response to rate hikes will be a particularly orderly one, either. “Volatility will continue rising, we will see more volatility on a cyclical basis,” he says. “Interest rates rising is never a smooth and orderly affair. Any time there is a big move in interest rates, issuers get scared and the banks guide them to wait for stability, which will lead issuance to dry up.”
But others argue to the contrary. Roy Scheepe, client portfolio manager at NN Investment Partners, says he is “positive about the next 12 months”. He expects fewer, well flagged and orderly hikes.
For Scheepe, EM still offers value on both a relative and an outright basis, and while he is mindful that rising US rates will have an adverse effect on the asset class in the longer term, he does not see this as a problem over the next 12 or so months.
“One of the big issues is US monetary policy, and if that is going to change, so the attractiveness of emerging market debt will be affected, but you have to question how likely that is,” says Scheepe.
“If you look at the yields of EM hard currency bonds, the spread over US Treasuries is roughly 300bp, which is still attractive, and there is still a strong case to invest in EM debt,” he adds. “If the spread tightens to the 200bp-250bp level, clients may begin to look elsewhere.”
Scheepe, like many other portfolio managers, warns that “quicker and stronger” Fed hikes could cause an upset, but he does not expect that to occur.
As for US policy, and the misfires of its erratic president risking market upset, Scheepe says people are “getting used to it”.
“It is very difficult to name a plan he has executed. Is there going to be tax reform? We don’t count on it.
“There are risks in the investment universe but that’s mostly developed markets. We expect the change in Fed policy will affect interest rates, but not to a level where we are very concerned. I expect two hikes in 2018.”
Return of the tantrum?
A big concern for investors is the risk of rapid capital flight in the vein of 2013’s “taper tantrum” which occurred when the then US Federal Reserve chair Ben Bernanke first indicated the end of QE.
BNPP AM’s Carter says there is a very real risk of what he refers to as an “inflation tantrum”. “The market is not positioned for a pick-up in inflation,” he says.
JP Morgan’s head of CEEMEA syndicate, Nick Darrant, also warns that the market had, in 2017, already showed signs of nervousness, though he notes that investors are increasingly able to isolate idiosyncratic events, reducing the risk of contagion.
“Geopolitical surprises, as seen in Q4, can serve as a bit of a trigger for investors to take stock of where they are putting their money,” he says. “If valuations get too stretched and the inflow of cash stops, then such a trigger could create a messy unwind.”
Fidelity’s Greer says that a 3% yield for the 10 year Treasury is the “inflexion point” for emerging markets, and would seriously eat into EM total returns, but he doesn’t expect that level to be hit for some time.
By late November, the 10 year Treasury was yielding 2.4%. The last time the yield of the US 10 year Treasury reached 3% was in December 2013. Greer’s confidence also lies in the fact that most EM investors have proved themselves to be resilient to recent back-ups in Treasury yields.
“We have seen a back-up in rates of 35bp in 10 year Treasury and [positions] haven’t moved that much,” says Greer, referring to the period between early September and late October. “It all depends on the pace of the move. If they go to 3% tomorrow, EM will be very tough.”
Stronger case to stay
Greer also points out that EM countries are in a stronger position than they were in 2013.
“EM growth is stronger than it was five years ago, inflation is pretty low, current account balances are in much better shape, currencies have depreciated and while there are still fiscal challenges [many issuers have IMF programmes to mitigate those challenges],” he says.
This sentiment is echoed by Shahzad Hasan, portfolio manager at Allianz Global Investors, who expects the supportive market conditions to continue well into 2018.
“EM growth picked up last year,” he says. “The EM growth cycle is on a rebound. I am not seeing a catalyst for a sell-off in the near term. The Treasury yield curve is flattening, which is supportive for EM sovereigns.”
Jan Dehn, chief economist at Ashmore in London, thinks inflows into the asset class will continue. “Only one-fifth of the money that institutional investors have taken out of the asset class in the past five years has returned,” he says. “There is still a pretty light positioning in EM, and it is pretty sticky. We won’t see a huge sell-off in EM, and investors should use any sell-off to add to positions. EM asset managers have been conservatively positioned and there has been more money coming in, with less of that being put to work, so we are in a strong technical position for 2018.”
But Allianz GI’s Hasan warns investors not to lower their guards.
“The market is going to fall on factors we haven’t thought about,” he says. “All the sell-offs in the past 10 years — Lehman brothers, the eurozone debt crisis, the taper tantrum — no one saw them coming. So all the reasons people are expecting for a sell-off now won’t be the trigger.”
Longer-term vulnerabilities
Within the asset class itself, certain bubbles, though not necessarily new, are building. Debt metrics are deteriorating and a historical reliance on dollar funding is going to hurt some countries.
In November, Standard & Poor’s published a report naming a new “Fragile Five”. The phrase originates from a Morgan Stanley report in 2013 which named Indonesia, South Africa, Brazil, Turkey and India as the countries most at risk of US monetary policy returning to pre-crisis norms.
S&P named Turkey, Argentina, Pakistan, Egypt and Qatar as its new Fragile Five, with Turkey appearing the “most vulnerable” based on several different variables.
In October, Moody’s analyst Anne Van Praag warned that benign global markets have spurred a sharp increase in the dollar denominated debt stock of frontier markets, but rising global interest rates will leave many unable to pay back increasingly expensive dollar debt.
Moody’s identified Mongolia, Mozambique, Egypt and Belize as most vulnerable to rising interest rates, on account of high leverage and weak institutions.