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Emerging Market Debt: Revisiting the Trouble Spots

The performance of emerging market (EM) debt has exceeded investor expectations so far this year, thanks to falling US Treasury yields and the persistence of broadly accommodative global monetary policies and low volatility in the capital markets. While these benign conditions could continue for some time, MFS’ experts Robert M. Hall, Institutional Fixed Income Portfolio Manager, and Matthew W. Ryan, CFA, Fixed Income Portfolio Manager, review the primary systemic, global risks for EM debt, along with the idiosyncratic, country-level events that have dominated the headlines. As valuations stretch and liquidity recedes, the portfolio managers anticipate that the market will increasingly differentiate among EM credits based on the issuers’ fundamental strength.

Global rates and monetary policy

Central banks of major developed markets (DM) have tried to suppress rate volatility and keep rates artificially low, and they have largely succeeded. According to MFS, intervention by the US Federal Reserve has contributed to Treasury yields that are too low given underlying growth trends. If US economic activity continues to improve, and the Fed’s forward guidance takes a more hawkish tone as a result, Treasury yields are likely to rise, creating a headwind for EM debt and other bond sectors.

How EM debt fares in this scenario would depend on the speed and size of the rate movement. MFS is inclined to expect a more muted and gradual move in Treasury yields this year than last year, when the magnitude of the rate spike prompted a wave of selling that pushed EM spreads wider.

Country-level events

Earlier this year, MFS singled out Venezuela, Argentina and Ukraine, which they called the Terrible Three because these markets all hit crisis points at the same time. How does MFS view these situations now?

Venezuela. MFS remains concerned about the ineffectual policy responses to the challenges facing Venezuela. While the devaluation of the bolivar earlier this year could have been a step in the right direction, it needed to be accompanied by fiscal and monetary restraint. Instead, increased fiscal spending and further monetary growth has fed surging inflation.

By nearly every metric, the economic and financial situation in Venezuela continues to show signs of stress and deterioration. Foreign exchange reserves are low, potentially straining the country’s ability to honor its debt obligations. Yet with the risk-on carry trade still in play, the market appears to be willing to accept the government’s market-friendly rhetoricat face value. In the absence of any policy improvements, MFS continues to believe that Venezuelan debt dynamics are ultimately unsustainable.

Argentina. Argentina has defaulted on coupon payments to investors in its foreign-law, restructured sovereign bonds. Though the technical default will likely have adverse implications for the country’s economic and financial conditions, Argentina has indicated a commitment to service its US dollar- denominated debt governed by local law. MFS believes the yields on those bonds offer reasonable compensation given current risks.

As the outcome remains difficult to predict, MFS is watching the ongoing developments and continually reassessing the risks related to this fluid situation. Longer term, one bright spot is the prospect for a more market-friendly regime following next year’s election.

Ukraine and Russia. Tension between Ukraine and Russia has remained high, and the likelihood of a near-term resolution appears remote. The ongoing conflict has a negative impact on economic activity and, by extension, Ukraine’s ability to meet structural targets established in the reform program backed by the International Monetary Fund (IMF). External funding from the IMF as well as the United States and the European Union has provided a critical fiscal lifeline, yet it will almost certainly become necessary for Ukraine to obtain additional assistance. MFS thinks this could increase the risk of a “bail-in,” with private investors forced to share the burden by having a portion of their debt written off.

Even though the Russian economy could be pushed into recession by the economic sanctions, the Putin government may be willing to endure such an outcome to achieve its broader politicaland security goals.

For now, Russian sovereign credit metrics remain quite strong, with a balanced fiscal account, large foreign exchange reserves and a growing current account balance. Recognizing that valuations could widen to the point where they offer reasonable compensation for heightened risk, MFS continues to monitor the situation closely for possible investment opportunities.

Areas of opportunity

Areas of opportunity still exist within EM debt, yet after solid gains in bond prices, valuations in aggregate appear less attractive now than in early 2014, according to MFS’s team. As US dollar-denominated EM sovereigns and corporates have recovered their losses from2013’s “taper tantrum,” risk/reward relationships have become less compelling, leaving MFS with modest expectations for the performance of EM debt for the rest of the year. Nevertheless, they believe that relative to many other fixed income assets, EM debt valuations are not as stretched.

Although local currency EM debt has yet to fully recover from last year’s selloff, MFS believes that EM currencies may have the highest beta to possible global financial turmoil, given their liquidity and the need for additional macro adjustments in certain EM countries.

In their view, with asymmetric risk to both interest rates and credit spreads, as well as geopolitical and idiosyncratic risk, this is an environment that calls for exercising caution when investing in EM debt.

Bond Yields Suggest an Unlikely Recession in Europe

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A pesar de la baja rentabilidad de los bonos, Robeco contempla pocas probabilidades de recesión en Europa — Léon Cornelissen, Robeco's Chief Economist. Bond Yields Suggest an Unlikely Recession in Europe

Eurozone bond yields are now so low they suggest a recession is imminent, though the European Central Bank’s dramatic action in September along with other more positive macroeconomic factors make that unlikely. Rates were cut again after the Eurozone recovery came to a halt in the second quarter. GDP growth amounted to exactly 0.0% compared to the previous quarter, while gross fixed capital formation dropped 0.3%. The German economy shrank, somewhat surprisingly underperforming France, and the third-largest economy, Italy, fell back into recession. The economic impact of the Ukraine crisis has been much larger than expected, primarily due to its confidence- damaging nature. As a consequence, bond yields have come down to amazingly low levels: German 10-year yields are currently below 1.0%, and Italian yields are currently 2.3%. For the privilege of lending up to three years’ money to governments such as Germany, investors now pay a premium.  The continuing relentless bull run on bond markets was the striking development this August. Aside from the weakening of the European economies, the downtrend in actual inflation and the growing fears of Japanese-style stagnation that can all explain these low yields, they are also a reflection of the likelihood of further aggressiveness by the European Central Bank. ‘Don’t fight the ECB’ could be an appropriate motto. Léon Cornelissen, Robeco’s Chief Economist, considers the likelihood of a new European recession to be small. Robeco expects a stronger third quarter for a number of reasons and continue to expect an ongoing recovery of the Eurozone economy. The main risk to this scenario would in our opinion be a severe further escalation of the tensions between the West and Russia.

Ukraine crisis ending in a frozen  conflict? 

Evidence is mounting that the  German economy is being hit by the  ongoing jitters over the Ukraine  crisis. German businesses are very  cautious about making new  investments. Gross fixed capital  formation declined 2.3% in the second quarter. But the Ukrainian  crisis is now showing signs of  becoming less heated. Russia has  made it clear that it won’t allow a  destruction of the pro-Russian  separatist region in Eastern Ukraine by sending sufficient troops and weaponry. On the other hand it has demonstrated a cautious attitude because the change in the military balance has not resulted in an offensive to take cities such as Odessa or Kiev. The logic of the situation suggests a stalemate, a so called ‘frozen conflict’. The Eastern Ukrainian provinces including a land bridge to recently annexed Crimea will remain firmly under Russian control, but hostilities will end, paving the way for what will most likely be long-winded negotiations. The current, rather weak sanctions will remain in place, with limited economic impact. Under these circumstances business confidence in Europe could rebound.

Of course, the current de-escalation in Ukraine could in the end turn out to be a “judo-inspired trick” by Russian President Vladimir Putin, who has a black belt in the sport. During the winter, when Europe is much more vulnerable to an immediate cut-off of Russian gas, tensions could rise again, though it should be kept in mind that countries such as Germany are already in a position to withstand a five-month boycott. The ultimate aims of the Russian leadership remain unclear. It could easily decide to stir up ethnic tensions in the Baltic region. Possibly we have only seen a couple of moves in what could turn out to be a very long chess game. We cannot be sure. But for the time being, our baseline scenario is a de-escalation of the conflict.

Shale gas revolution helps world economy

Eastern Europe is not the only region in which geopolitical tensions are flaring up. The Islamist insurgency in Iraq is a potential threat to oil supply, although Brent oil prices are trending down from their peak in June. An important factor is the shale oil revolution in the United States. It is currently acting as a ‘supplier of last resort’, a role earlier taken by Saudi Arabia. It is highly uncertain how long the shale oil revolution will last, but the currently well-behaved oil prices are a boon for the world economy, including the Eurozone. The price of oil is an important factor driving down headline inflation. Core inflation in the Eurozone is still 0.9% on a yearly basis, despite all the talk about deflation.

Accommodating monetary policy weakens the euro

The ECB played its part by marginally lowering interest rates to 0.05% and announcing a buying program of Asset Back Securities (ABS), suggesting a possible size of one trillion euros. As the current European ABS market is not well developed, this potential size looks ambitious. It will take time to implement the ABS program and its beneficial effects will be gradual. But in so far as the program helps to weaken the euro it immediately benefits European exporters. Very strong confidence indicators in the US (an ISM manufacturing reading of 59, non-manufacturing 59.6) benefit the US dollar as well. The ECB has still one weapon of last resort – generalized QE of sovereign bonds. But this weapon will only be used if the European economy weakens materially further. This option remains clearly on the table and will help keep down the euro and long-term interest rates.

Macro outlook: Fiscal policy is no longer restrictive

During the Jackson Hole summit, ECB president Mario Draghi sketched the outline of a grand bargain, in which the ECB would do more in exchange for fiscal stimulus (in Germany) and structural reforms (in France and Italy). Chances of meaningful reform packages in France and Italy are low, but there is already a political agreement about a flexible interpretation of existing budgetary rules within the Stability and Growth Pact. Automatic stabilizers in the Eurozone will as a consequence probably get more room to maneuver in the coming months and governments within the Eurozone will start to make a more positive contribution to economic growth.

Remarkably low interest rates and tight sovereign spreads within the euro area will stay with us in the coming months as long as the ECB keeps its easing bias, confirms Robeco’s Chief Economist. The search for yield implies that the Eurozone is currently exporting low interest rates to the US, where 10-year bonds offer a yield of about 2.5%. But as the US economy will continue to strengthen, talk about the timing of the first interest rate hike will get louder, and gravity could be reversed: US long-term interest rates may push up those in Europe. A necessary condition would be a resumption of the European recovery, which partly depends on geopolitical developments. Our baseline scenario is a stronger Q3 GDP which will diminish pessimism about the European recovery. As a consequence Robeco sees little value in European and US government bonds at current yields.

Bestinver’s Parames Leaves for New Project

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García Paramés deja Bestinver para emprender un nuevo proyecto profesional — Francisco García Paramés. Bestinver’s Parames Leaves for New Project

Bestinver Asset Management’s fund manager Francisco Garcia Parames will be leaving the company to start a new project, according to a statement released by Efe.

Parames has spent 25 years at Madrid-based Bestinver where he managed above €7.5bn in Spanish and international stocks. The portfolio manager, known as the “European Warren Buffet” because of his pure value style, has achieved one of the highest returns in the market during this period placing his funds amongst the first places of their category.

The fund manager moved to London from Madrid in June 2013, where he worked with two associates, Alvaro Guzman de Lazaro and Fernando Bernad. Parames thanked Bestinver, part of the Spanish construction conglomerate Acciona, as well as all the investors who trusted him with the management of their savings, for “providing him with the opportunity to develop an exciting professional career”.

Rediscovering European Loans

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Redescubriendo los préstamos europeos — Foto cedidaDavid Milward, Head of Loans at Henderson. Rediscovering European Loans

The European loan market has experienced something of a revival over the past 18 months. 2013 saw by far the largest volume of issuance for several years, while 2014 is on track to record an even higher total. Volume reached €50bn in the first half of 2014, a 16% increase on the same period last year.

Secured loans make up a significant and growing portion of the broader European loan market. Known as ‘secured’ because they typically have first priority over the assets of a company in the event of a default, secured loans are an important source of debt financing for non-investment grade businesses, alongside the high yield market. Despite the increased level of supply in recent months, demand for secured loans has remained strong. Investors have been attracted to secured loans in part due to expectations that short term interest rates will rise over time, given that loan yields are linked to these rates.

Issuance volumes in Europe have been driven by a mixture of refinancings from existing issuers, merger and acquisition (M&A) activity and private equity/management buyouts. The second half 2014 has started strongly, with a healthy pipeline of deals still due to come to the market over the next few months. While secured loan issuance is still some way off the levels seen previously, as shown in the chart below, it seems confidence in the loan market has returned from both issuers and investors.

Western European new institutional leveraged loan issue volumes

Source: Henderson Global Investors, Credit Suisse, S&P LCD, as at 30 June 2014.

In 2014 there has been a revival of large M&A deals in Europe, many of them funded by loans. Numericable, a French cable business, acquired SFR, a French telecommunication company, in the spring of this year. The financing included €5.6bn of loans alongside high yield bonds as part of a record €15.8bn debt package. Boots, a UK pharmacy, which is soon to be merged into the US firm Walgreens, previously held the record for the largest loan-funded leveraged buyout.

Other well known companies to tap the loan market this year include Formula One, the motor sport operator, and Saga, a UK based insurance and leisure company.

The increase in issuance has allowed the secured loans team to selectively add new loans to their portfolios this year, focusing on larger businesses with predictable cash flows and a proven track record throughout economic cycles.

Robeco and Team Brunel – Pioneers With a Passion for Data

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Foto: Ryyta, Flickr, Creative Commons. Surcando nuevos mares: Volvo Ocean Race

There are many such parallels between sailing around the world and successful investing. Both combine technical know-how with careful risk management. And both require teamwork to win over the long term.

That is why Robeco was delighted to become sponsor of Team Brunel, the Dutch entry in the Volvo Ocean Race 2014-15. This round-the-world race will see eight boats compete, starting out on 1 October. It will take nine months to complete this epic voyage, calling at nine stopover ports along the route.

The sponsorship is a natural fit. A pioneering spirit has long been embedded in Robeco’s DNA. We were the first to take sustainability investing seriously, among the first to invest in emerging markets and one of the original users of quantitative investing models.

Quant on the high seas

Quant expertise is also being used by Team Brunel to help with data collection and navigation, and to minimize risks. “We use quantitative analysis by collecting facts just like Robeco does before considering an investment,” says Bouwe Bekking, skipper of the Team Brunel boat. “We try to get as many facts and numbers as possible. We have to sail through 360 degrees and have to cover all the possible angles for every wind direction, each one requiring different sails.”

“There are so many angles involved when sailing over the ocean – the wind, the weather, the size of waves – that we use as many combinations of data as possible to match it to the real conditions of the day. We put it all in the model and then implement this information to predict velocities in all sailing conditions. The more combinations we can check out to see how fast the boat will go, the better.”

“Obviously the faster you go at sea, the more you need proper risk management, or the chance of you hitting an iceberg or a whale becomes very large. It’s the same with investing,” says Peter Ferket, head of equity investments. “We want to take active risks, and we look for opportunities, but at the same time risk management is key to avoiding the bad parts of the market.”

“Our quantitative investment approach is deeply embedded throughout the organization to support this. It is directly connected to the use of as much data and information as possible. But we don’t just look at a company’s past results; we regularly meet with management and look at companies’ qualitative information in order to blend insights that are both forward and backward looking.”

“We also use non-financial information in our assessment of a company to decide whether or not it is an attractive investment. Something that might look like a great opportunity on the surface needs a deeper look to avoid disappointments.”

“And we also consider environmental, social and governance (ESG) factors and quantitative analysis as risk indicators. So if a stock gets in the portfolio but drops in the ESG or quant rankings, then this is a signal for us to take a deeper look at the company.”

Coping with data in all conditions

Using quantitative and other research for risk management relies on accurate data, particularly in new terrain. This presents challenges for sailors and investors alike.

“Using data works well to sail from Alicante to Cape Town for example, but the real problem is in places like China where the data and charts are really bad,” Bekking says. “So we have to make risk calculations. For example, the draft of the boat is five metres, so we need to know how deep the water is and make calculations so that the keel is always higher.”

“The bigger problem is the weather. In the northern hemisphere the weather forecasts are really accurate and you can even plan on how the wind will change on an hour-by-hour basis. But once you get into the southern hemisphere, sailing for example from Abu Dhabi to China, models for weather forecasting are much less developed and can be completely wrong.”

“You then have to start making assessments; positioning yourself in relation to the competition but without being able to trust all the information. We have to decide: do we split from the others, and put all our eggs in one basket, or follow suit and take no risk in terms of positioning?”

It’s a marathon, not a sprint

Both Robeco and Team Brunel know that taking short cuts can be tempting, particularly if the circumstances are rough. But the Volvo Ocean Race is a marathon, not a sprint, and it is important to keep a steady hand on the tiller. This applies both at sea and in the office.

“A short cut can save you time, but you need to be aware of the risks this can entail,” Ferket says. “Typically we aim to achieve good performance in all conditions; we don’t want to be the best when markets are rallying and then the worst when they fall. We want to be the best over a long period and also do well when markets are in decline.”

“It is similar to winning the Volvo Ocean Race. It’s no good winning one leg, and then performing poorly in the next one, or not even reaching the finish line. Our goal is to deliver added value over a three to five-year horizon, which consists of many different legs in different market conditions. Being the best this year and the worst next year doesn’t work for us.”

Risk management as a life saver

And while investing can be painful at times, for Bekking careful risk management can be a matter of life or death.

“My worst nightmare is losing a crew member in a rough sea,” he says. “A boat is replaceable but a person is not. There’s not much risk of hitting something – I’ve only ever seen one whale, the first time I went round the world in 1985, but there are icebergs in the Southern Ocean, and so safeguards are in place. We just keep north of the dangerous areas; our boats now go at 30 knots and hitting something would be like driving your car into a wall at 70kph. We’d be pretty smashed up.”

“We have tried to find the limits of this particular boat, as it’s a new design and all the safety margins have been set way higher than for the last one. And we’ve tested the crew, of course, to see how the new guys cope. Once we start racing, we will push even harder, and so any problems found beforehand will help us. We’re really looking forward to the race.”