Time for generating alpha
Time for generating alpha
Alejandro Arevalo, Alejandro Di Bernardo, Reza Karim and Xuchen Zhang say emerging markets debt could offer a positive environment over the next six to twelve months, with alpha generation hinging on credit selection.
After a very challenging 2022, the first half of 2023 has been more generous for emerging market debt investors. Last year’s adjustment has been painful, but the asset class provided much higher carry as a starting point for 2023 and investors shrugged off some volatility to realize such carry.
Selectivity will be key in order to continue to capture such positive carry in both sovereign and corporate debt. In this sense, we do think the next six to 12 months could be a positive environment for credit pickers, but the journey might not be smooth.
Selectivity will be key in order to continue to capture such positive carry in both sovereign and corporate debt. In this sense, we do think the next six to 12 months could be a positive environment for credit pickers, but the journey might not be smooth.
US: lower growth and inflation means fall in Treasury yields
Indeed, 2022 was the year of inflation, which meant that fixed income investors had to make painful adjustments. As central banks frantically tried to quell inflation that proved to be much more entrenched than earlier thought, government bond investors grappled with an abrupt change in reality.
While focused on EM, as dollar-denominated debt investors, we always keep an eye on the potential trajectory of US macroeconomic developments. We are cautiously optimistic on the inflation picture in the US, but this will probably come at the cost of a slowdown in the US economy.
We believe from now on the US Federal Reserve (Fed) should probably enter a fully data-dependent stance. As natural lags in monetary policy play through, we see low chances of a much higher level of terminal rate. This means US Treasury yields should start declining from here, or at least remain more stable than what we witnessed in the past 12/18 months.
Key consequence for us is to keep generally an overweight stance to interest rate exposure.
While focused on EM, as dollar-denominated debt investors, we always keep an eye on the potential trajectory of US macroeconomic developments. We are cautiously optimistic on the inflation picture in the US, but this will probably come at the cost of a slowdown in the US economy.
We believe from now on the US Federal Reserve (Fed) should probably enter a fully data-dependent stance. As natural lags in monetary policy play through, we see low chances of a much higher level of terminal rate. This means US Treasury yields should start declining from here, or at least remain more stable than what we witnessed in the past 12/18 months.
Key consequence for us is to keep generally an overweight stance to interest rate exposure.
China: more stimulus ahead, but will it be enough?
It is fair to say that China’s recovery after Covid hasn’t matched investors’ expectations. What we’ve seen so far is a mostly services-driven recovery, with manufacturing lagging behind. Latest Purchasing Managers’ Indices (PMI) data show manufacturing contracting. CPI is on the verge of deflation, while Producer Price Index (PPI) is already in proper deflationary territory. This might be a positive news for those looking for global disinflation but paints a grim picture for demand in China.
Naturally, the reaction has been one of additional support both in terms of monetary policy and continuation of targeted relief measures for the property sector. A somewhat less hawkish stance vs large private corporations in the technology space has emerged as well. In a nutshell, we have seen a pivot from idealism to pragmatism.
We think there will be more stimulus and more support for the property sector and the broader economy in the pipeline. This positions us in the middle camp when it comes to our degree of conviction on Chinese growth. We believe the 5% growth target is reachable, but we do not expect huge upside surprises.
When it comes to property, we think that the issues of demand are more structural than cyclical. It is hard to conceive what kind of public support might completely solve the imbalances.
Naturally, the reaction has been one of additional support both in terms of monetary policy and continuation of targeted relief measures for the property sector. A somewhat less hawkish stance vs large private corporations in the technology space has emerged as well. In a nutshell, we have seen a pivot from idealism to pragmatism.
We think there will be more stimulus and more support for the property sector and the broader economy in the pipeline. This positions us in the middle camp when it comes to our degree of conviction on Chinese growth. We believe the 5% growth target is reachable, but we do not expect huge upside surprises.
When it comes to property, we think that the issues of demand are more structural than cyclical. It is hard to conceive what kind of public support might completely solve the imbalances.
EM ex-China: welcome disinflation
One of the most surprising outcomes of the Covid cycle was an unusual occurrence in which inflation in the developed markets surpassed inflation in EMs (on aggregate).
One key factor that has helped EMs to avoid a sharp acceleration in inflation is the credibility shown by central banks. Rate hiking cycles in EMs started well before what was seen in developed markets. While developed economies grappled with a rise in services sector inflation, it is a smaller component of consumer price baskets in EMs. The asset class also benefited more from commodity price disinflation.
The net result is that today EM central banks sit on a meaningful cushion of positive real rates. This might help to ease monetary policy and support economies down the line, but we do not expect a massive round of rate cuts from here. We think EM central banks are going to mostly follow the Fed, as the price for early easing might be excessive currency depreciation.
The net result is that today EM central banks sit on a meaningful cushion of positive real rates. This might help to ease monetary policy and support economies down the line, but we do not expect a massive round of rate cuts from here. We think EM central banks are going to mostly follow the Fed, as the price for early easing might be excessive currency depreciation.
Market view
EM Corporates: positive fundamentals
The fundamentals of EM corporates remain positive. Compared to historical data and developed markets, net leverage is relatively low, which is a significant advantage for the asset class.
Looking ahead, we anticipate the potential for increased dispersion. One key factor that has benefited many corporates in 2023 has been the manageable wall of refinancing. However, in the coming years, this maturity wall is expected to become more challenging. We perceive a certain level of refinancing risk due to the rising cost of debt that many issuers will have to confront following the recent sharp tightening cycle. In addition to bonds, the rollover of loans poses an additional refinancing risk, particularly for certain unique situations that could potentially impact the market on a broader scale.
While we still identify interesting opportunities within the asset class, our approach to evaluating corporates has evolved. Previously, we sought growth stories that could outpace their debt, but now we prioritize resilient stories that can navigate the refinancing cycle without difficulty or those that have already taken proactive measures. On the other hand, the reason for the refinancing risk can be attributed to relatively weak net new issuance, which has remained negative throughout 2023. This low net issuance continues to be a positive technical factor. From a valuation standpoint, although there has been some volatility, we are currently not far from where we began the year.
Most of the positive performance has been driven by the natural carry of positions, underscoring the validity of the yield story that was highlighted at the start of the year. We believe the current environment offers the potential for attractive returns, provided that caution is exercised in avoiding weaker names on the refinancing list. This is a time where alpha and credit selection can be particularly advantageous.
Looking ahead, we anticipate the potential for increased dispersion. One key factor that has benefited many corporates in 2023 has been the manageable wall of refinancing. However, in the coming years, this maturity wall is expected to become more challenging. We perceive a certain level of refinancing risk due to the rising cost of debt that many issuers will have to confront following the recent sharp tightening cycle. In addition to bonds, the rollover of loans poses an additional refinancing risk, particularly for certain unique situations that could potentially impact the market on a broader scale.
While we still identify interesting opportunities within the asset class, our approach to evaluating corporates has evolved. Previously, we sought growth stories that could outpace their debt, but now we prioritize resilient stories that can navigate the refinancing cycle without difficulty or those that have already taken proactive measures. On the other hand, the reason for the refinancing risk can be attributed to relatively weak net new issuance, which has remained negative throughout 2023. This low net issuance continues to be a positive technical factor. From a valuation standpoint, although there has been some volatility, we are currently not far from where we began the year.
Most of the positive performance has been driven by the natural carry of positions, underscoring the validity of the yield story that was highlighted at the start of the year. We believe the current environment offers the potential for attractive returns, provided that caution is exercised in avoiding weaker names on the refinancing list. This is a time where alpha and credit selection can be particularly advantageous.
EM sovereign
EM sovereign debt (in hard and local currency) has been enjoying a positive ride since the beginning of the year. Many positive (and often unexpected) idiosyncratic stories started to play out, spurring a strong recovery in the valuation of some more complicated names.
Ukraine, Turkey, Nigeria, Egypt, Pakistan, Ghana and Zambia have seen positive developments. We think the “high yielding” countries still offer interesting opportunities at the moment.
When it comes to “high-grade” or in any case larger countries, instead, we think that the local market can offer some interesting opportunities given the high real yield cushion (on expected inflation) enjoyed by many countries such as Brazil, Indonesia or Hungary.
When it comes to “high-grade” or in any case larger countries, instead, we think that the local market can offer some interesting opportunities given the high real yield cushion (on expected inflation) enjoyed by many countries such as Brazil, Indonesia or Hungary.
Regional views
Europe
While Europe might be a relatively small component of our universe, the region has been lately enjoying positive surprises.
Ukraine has been the most positive story so far this year. International support and solid possibilities of an internationally financed reconstruction plan are part of the story. As corporates and segments of the economy continue to function even in an extremely complex setup, investors have been willing to buy the country’s debt.
Further east, countries such as Azerbaijan, Kazakhstan or Uzbekistan offer interesting opportunities especially in the energy sector, but interesting idiosyncratic opportunities can be found also in more peripheral countries such as Georgia or Moldova.
We remain overweight the region.
Ukraine has been the most positive story so far this year. International support and solid possibilities of an internationally financed reconstruction plan are part of the story. As corporates and segments of the economy continue to function even in an extremely complex setup, investors have been willing to buy the country’s debt.
Further east, countries such as Azerbaijan, Kazakhstan or Uzbekistan offer interesting opportunities especially in the energy sector, but interesting idiosyncratic opportunities can be found also in more peripheral countries such as Georgia or Moldova.
We remain overweight the region.
Africa
The big positive of late has been Nigeria, thanks to an unexpected agenda of reforms from the new government. We recently reengaged in the country and find additional safety when investing in USD-earners.
We are less enthusiastic about South Africa, mostly because relative valuations are less interesting.
The rest is effectively mostly about single name stories that we consider detached from the broad macro picture in the region, which remains highly diverse. Countries where we are currently active are for example Mauritius, Morocco and Tanzania.
We remain overweight the region.
We are less enthusiastic about South Africa, mostly because relative valuations are less interesting.
The rest is effectively mostly about single name stories that we consider detached from the broad macro picture in the region, which remains highly diverse. Countries where we are currently active are for example Mauritius, Morocco and Tanzania.
We remain overweight the region.
Middle East
Oil prices have benefited countries such as Saudi Arabia, UAE or Oman, with a massive improvement in fiscal balances. Kuwait alone has seen its budget deficit improve by roughly 19% during the year.
Fundamentals already reflect all of this, and valuations have been pretty resilient around the wide levels seen in 2022 , making valuations more expensive across some issuers on a relative value basis. 2023 has seen some underperformance in the corporate space that has prompted us to once again increase exposure.
When investing in large countries (e.g. UAE, Saudi Arabia), we prefer to express our allocation via more interesting sectors such as real estate, financials or logistics. Otherwise, we find some interesting opportunities in the HY space (e.g. Oman). We remain overweight the region.
Fundamentals already reflect all of this, and valuations have been pretty resilient around the wide levels seen in 2022 , making valuations more expensive across some issuers on a relative value basis. 2023 has seen some underperformance in the corporate space that has prompted us to once again increase exposure.
When investing in large countries (e.g. UAE, Saudi Arabia), we prefer to express our allocation via more interesting sectors such as real estate, financials or logistics. Otherwise, we find some interesting opportunities in the HY space (e.g. Oman). We remain overweight the region.
LATAM
After being positive on the region for a relatively long time we recently switched our stance to more neutral. Our view of a somewhat slowing cycle demands a lower cyclical exposure, and the region is home of various cyclical corporates in basic materials or industrial sectors.
Monetary policy remains a positive aspect in LATAM. Central banks have been fighting to keep their reputation intact. In recent quarters policy, their policy has shown however some volatility as seen in the likes of Peru, Brazil, Colombia and Ecuador.
Our favourite country at the moment remains Mexico thanks to nearshoring opportunities and a combination of stable politics, positive growth and high real rates. The country offers interesting opportunities in defensive sectors such as utilities or telecommunications as well as some good value across financials. Other countries where we find interesting are Paraguay, Panama and the Dominican Republic. Brazil offers a good opportunity in local currency bonds. We expect growth to decelerate in the second half of the year, although from a strong base and one of the highest in the region. We remain cautious in Chile, where growth continues to disappoint, and we now expect flat growth for the year.
We are currently neutral the region.
Monetary policy remains a positive aspect in LATAM. Central banks have been fighting to keep their reputation intact. In recent quarters policy, their policy has shown however some volatility as seen in the likes of Peru, Brazil, Colombia and Ecuador.
Our favourite country at the moment remains Mexico thanks to nearshoring opportunities and a combination of stable politics, positive growth and high real rates. The country offers interesting opportunities in defensive sectors such as utilities or telecommunications as well as some good value across financials. Other countries where we find interesting are Paraguay, Panama and the Dominican Republic. Brazil offers a good opportunity in local currency bonds. We expect growth to decelerate in the second half of the year, although from a strong base and one of the highest in the region. We remain cautious in Chile, where growth continues to disappoint, and we now expect flat growth for the year.
We are currently neutral the region.
Asia
Asia has been a structural underweight for a long time for us. For both sovereigns and corporates, there are a lot of investment grade issuers with tight spreads offering limited space for value generation through credit selection. Debt issued by the region’s corporates is a very meaningful component of indexes (over 40%), which we as credit selectors find it unnecessary to match in terms of our regional allocation.
More recently, as we became more defensive, we started to reengage with some of the investment grade names in the region. Thanks to higher underlying rates, we can lock up attractive carry from very high-quality issuers.
Leaving aside large investment grade capital structures, the HY component in Asia remains highly volatile and especially in China. Markets are prone to sizeable sudden shifts as unexpected defaults or weak earnings alternate with new speculations on possible government intervention. Therefore, we avoid large fundamentals based active positions in the country as daily technicals remain highly unpredictable. Indonesia and India look positive to us, thanks to a positive macro backdrop (solid growth, supportive policy and robust onshore liquidity) and a diverse set of corporate opportunities as well as interesting value in local currency.
We remain underweight the region.
More recently, as we became more defensive, we started to reengage with some of the investment grade names in the region. Thanks to higher underlying rates, we can lock up attractive carry from very high-quality issuers.
Leaving aside large investment grade capital structures, the HY component in Asia remains highly volatile and especially in China. Markets are prone to sizeable sudden shifts as unexpected defaults or weak earnings alternate with new speculations on possible government intervention. Therefore, we avoid large fundamentals based active positions in the country as daily technicals remain highly unpredictable. Indonesia and India look positive to us, thanks to a positive macro backdrop (solid growth, supportive policy and robust onshore liquidity) and a diverse set of corporate opportunities as well as interesting value in local currency.
We remain underweight the region.
The value of active minds – independent thinking
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