“Bad technicals” are almost all to blame for the 2013 summer of discontent over emerging markets fixed income, with the picture for 2014 on this front entirely more favourable, according to Ashmore. The outlook for emerging market fundamentals and valuations also look positive going forward.
In an outlook for emerging markets Jan Dehn, head of research and Gustavo Medeiros, portfolio manager at emerging markets specialist Ashmore question widespread assumptions that EM will experience the same massive outflows they experienced overall as a result of Fed hints of tapering earlier this year. They believe there are three good reasons why emerging markets should not experience same outsized, exit reaction the next time around: technical, fundamental, and valuation.
On the technical front they argue that barring an almost unprecedented reversal of the outflows from emerging markets during this year, the picture should be “significantly stronger” going into 2014.
Dehn and Medeiros remind that positioning in EM fixed income was already extended going into 2013 after investors had belatedly chased the opportunity created by the Greek default in the third quarter of 2011. Then, within the first four months of 2013, technicals deteriorated further as banks and leveraged fast money began to front-run anticipated Japanese real money flows into the asset class.
Against this extremely stressed technical backdrop, the Fed’s May tapering announcement catalysed 20 weeks of mainly retail and fast money outflows into a market with few buyers due to low summer liquidity and big uncertainties arising from US political issues, Fed succession, and expectations of tapering by September.
“In other words, the outsized reaction in EM fixed income relative to other fixed income markets was almost entirely due to bad technicals. By contrast, the technical picture as we approach 2014 is entirely more favourable.”
The fundamental picture for emerging markets is also better. Dehn notes that while EM asset prices went down over the summer, fundamentals improved, though he stresses the complexity of on this front: “There are more than sixty investable countries and hundreds of investable corporates in EM. And the asset class is growing very fast, rising by $1.3trn in the past 12 months alone.
“The variation in credit quality across this vast universe is enormous, far wider than, say, that of Germany and Greece. China bears little resemblance to Paraguay, Ecopetrol is a completely different company from neighbouring PDVSA, Korea’s Samsung bears little resemblance to Nigeria’s GT Bank, Ukraine’s MHP, or Jamaica’s Digicel, though all four are well run companies.”
Dehn concedes that at 4.5%, EM growth in 2013 has been disappointing, but he insists EM growth disappointed for the same reasons that growth in developed economies disappointed. The main culprit, he says, was a dip in the global manufacturing cycle, which took hold in late 2012 and extended into the first quarter Europe and the US were similarly very weak in the first quarter – US growth was expected to be 3.5% growth in that quarter but was revised to just 1.7%.
The final reason why Dehn and Medeiros think investors should be less wary of tapering by the Fed in 2014 is that EM valuations are far more attractive. He points out, firstly, that local currency bond yields have re-priced back to 2003-2007 average levels. The last time EM bond yields were at these levels was when 10-year US treasury yields were close to 4.5% and 5-year US treasury yields averaged nearly 4%. Today, the latter are trading closer to 2.7% and 1.4%, respectively.
Corporate bonds in EM have also cheapened significantly compared to identically rated US corporates. EM corporate high-yield and high-grade corporate bonds are trading at 1.6 and 1.9 times wider spread than identically rated US companies, respectively. Finally, they note, EM sovereign bond spreads have blown out to more than 300bps over US treasuries.