I recently attended a panel on emerging market (EM) corporate bonds and one of the speakers mentioned their extra caution (or even avoidance!) in investing in corporate issuers that have only issued a single bond. While the investor did not delve deeper into the topic, this is something I rarely pay extra attention to when investing in sovereign hard currency bonds. Most of the factors that apply to a single bond issue can also apply to an issuer that has issued a series of bonds.
- Assessing the issuer’s fundamental trajectory from an economic and political/policy making angle
- Ability and willingness to pay
- Transparency and governance
- Data quality and ability to monitor the credit subsequently
- Liquidity of the instrument
A major difference is that, while corporates may ‘disappear’ (go bankrupt, be merged, sold etc.), sovereigns rarely do. In fact, many sovereigns are serial defaulters with several bonds outstanding (Argentina, Ecuador etc). Their history has not prevented them from issuing new bonds once investors perceive new stability.
Are single issue sovereigns worse investments than countries with a well-developed curve?
Puzzled, I decided to review the sovereign hard currency bond universe to see if this is justified or not.
A first time issuer lacks a repayment track record and assessing the fair value of a debut issue can be challenging. However, many issuers have issued a single debut bond and have subsequently had successful further issues. Some of these matured and were repaid, or were refinanced with other new issues, cash or other types of debt. Other issuers have been less successful and have already or will have to restructure their bonds. There is also uncertainty over some single issues due to mature in the coming years (Maldives and Mozambique) and whether they will pay back in full.
Most of these issuers are smaller economies that cannot issue more than one bond. Many issuers chose to issue $500 million, which is the minimum amount required for inclusion in the JP Morgan EM Bond Index, a widely-used benchmark. In some cases, a single $500 million bond can be close to 10% of GDP! Some issuers (Namibia, Iraq, Rwanda) paid back earlier bonds, but some have restructured over the last few years (Mozambique, Suriname, Barbados) or are in the process of doing so (Ethiopia). Still, the overwhelming majority of the credits are high yield. In fact, Kuwait is the only investment grade credit and it has not issued additional bonds out of choice, as it consistently runs fiscal surpluses and has very little debt. Georgia is the rare BB credit which has also chosen not to issue additional Eurobonds.
Conclusion
As the 2023 returns show, these types of credits can often contribute to outperformance, if one gets the fundamental call right. Equally, things can end in tears if one gets the story wrong. While these credits are normally riskier and often require a deeper analysis than mainstream EM names, they should not be shunned altogether. In fact, the table includes one of our former investments, my beloved Tanzania 2020 floater, which matured and got fully repaid. We look forward to similarly interesting new opportunities in the future.
The beauty of procrastinating writing a year ahead outlook is that you can use more up-to-date assumptions in your forecast. Outlooks from the sell-side (and some buy-side too) started arriving in early-November. Assuming it took them a few days to write, edit and have it approved by compliance, it is possible that some of them were written while US treasuries were yielding close to 5%, about 1% higher than they are now. The massive rally in core rates throughout most developed markets since then begs the question of whether those return targets or views are still valid. The ‘higher for longer’ mantra quickly gave way to expectations of rate cuts from most developed market central banks by mid-2024.
The base case macroeconomic scenario for 2024 is favourable as inflation has receded in most economies, central banks have been or will soon be easing policy, and growth, while expected to slow down, may avert a recession. Having said that, this has pretty much been priced in by the markets and stickier inflation could lead central banks to cut far less than that which is priced in (over 100 bps of cuts in the US). This would lead to a backup on rates or a deeper economic slowdown that could lead to widening of spreads and lower equities, but a further rally in core rates.
Noteworthy elections include Indonesia, South Africa, Mexico, India and, of course, the US. Elections often produce volatility and investment opportunities and do not necessarily reflect downside risks. In fact, recent elections in Turkey, Poland and Argentina all led to a subsequent rally in asset prices on back of outcomes that led to improvements in economic policy making. Meanwhile, key geopolitical issues (Russia-Ukraine, Middle East and China-Taiwan) remain unresolved and the US elections are not helping to ease the uncertainty on this front.
We expect 2024 return drivers to be different to those in 2023
In sovereign hard currency, the outsized 2023 returns of high yield and distressed credits (for example, Venezuela, El Salvador, Pakistan and Sri Lanka, all returning between 70-150%!) will not be repeated as bond prices have reached the 60-80+ price range. Similar future returns would bring those bonds near par – levels consistent with BB credits, which they are far from. In fact, there were 15 countries that posted total returns above 15% for the year. Conversely, there are just a handful of issuers that have performed very poorly in 2023 (Bolivia and Ecuador), which limits the number of distressed credits that could return 50%+ or more in 2024. Therefore, we expect carry to take a larger role in 2024 returns as opposed to price appreciation.
A supportive factor is that many of the single B and below rated countries are trading now at single digit yields, meaning that they will have once again market access. Following a year where only one sovereign default occurred (Ethiopia), we may see a small number once again (Bolivia perhaps?), should current economic policies remain unchanged. It was also encouraging that Suriname managed to restructure its commercial debt and Eurobonds, with progress in other countries, namely Zambia, Sri Lanka and Ghana being much slower. Investment grade credits present limited opportunity for spread tightening, given that those are at multi-year tights, and whose scope for outperformance vs the high yield space will be mainly driven by US Treasuries.
Local yields saw the continuation of disinflation. For 2024, we expect the disinflation to slow as the key drivers fail to assist to the level that they did in 2023. For example, energy and food prices are unlikely to help as much as they did last year with service inflation being stickier at current levels. With most markets pricing in a range of -100 to over -400 bps in rate cuts, opportunities will be more selective and data dependent as opposed to the widespread rates rally we saw in 2023.
Still, even on a carry basis, we find plenty of attractive opportunities. For example, most local yields underperformed the recent rally of US Treasuries. Mexican local Bonos, which tend to be highly correlated with US yields given the close link between the two economies, not only yields over 5% above comparable US Treasuries now, but with less historical yield volatility given US Treasury volatility was very high over the past 6 months. In fact, it is quite remarkable that 10 year US Treasuries ended the year at 3.9%, almost exactly where they were at the beginning of the year, despite the very large moves we saw in the second half of the year. With both countries facing elections in 2024, I would argue that calling the US election and its subsequent policy stance is harder than calling Mexico’s.
We remain selectively constructive on EM currencies, as we do not expect the US growth to outperform EM growth or on its monetary policy trajectory (i.e. additional tightening). Valuations are generally not expensive, with the exception of a few currencies such as the Mexican Peso or Czech Koruna. Finally, investors seem to be underinvested in EM local bonds (see graph below), which faced stiff competition from high short term rates in the US, UK and Eurozone. That should improve going forward as those central banks start easing and short term rates decline (see second graph below). There is often a lag between positive returns and inflows – i.e. investors often chase returns, not anticipate them – and higher capital inflows are supportive for the currencies and/or for the accumulation of international reserves, which is credit positive.
Conclusion
While the double-digit returns we saw in 2023 may not be replicated again in 2024, emerging market debt still offers compelling opportunities, especially for investors that are facing the reinvestment risk from short-dated bonds. Even if returns converge to average (mid-to-high single digits), the asset class should not be overlooked.
With concerns about sticky inflation in the UK and following the Bank of England’s surprise hike to 5% today (versus 4.75% expected), here’s a surprising chart: EM inflation is lower than UK inflation for the first time in 20 years.
Drivers on the EM side:
- Proactivity of EM Central Banks – some (e.g. in Latin America) have been hiking since 2021, well ahead of developed market central banks
- Less monetary overhang than DMs as there was less (or no) QE in most countries
- Caveat on the graph above: this is GDP-weighted, so approximately 40% of the EM weight is China, where inflation is currently at only 0.2%. China, and to some extent Asia, saw much lower levels of inflation than the rest of EM (and DM), as there has been less energy price pressure and fewer supply side bottlenecks. The region was operating below potential growth in some countries and/or had more scope for some fiscal subsidies or price controls than other countries
Drivers on the UK side:
- The index in the chart above includes food and energy, which have been under particular pressure in Europe
- Rental prices are also a factor and have been elevated
- Brexit-related factors influencing supply chains / labour market?
Qatar’s choice as a World Cup host has received a fair amount of criticism, on the back of allegations of mistreatment of foreign workers, the environmental impact of hosting a large scale sporting event in the Gulf (even in winter) and the country’s stance towards the LGBT local community and visiting fans.
How does Qatar compare to other emerging market countries?
Following our tradition of World Cup themed blogs[1] we compared Qatar’s ESG scores with other 2022 World Cup participants based on our internal M&G sovereign scores, which we calculate based on a range of ESG and other risk factors, as well as MSCI’s.
Most emerging market countries that we invest in typically have lower ESG scores than developed countries, as their institutions tend to be less robust and in some cases they may be more prone to higher environmental risks, to no fault of their own. Further, ESG scores tend to be correlated with a country’s income level.
Qatar’s ESG scores rank it 24th among the 32 teams playing in this year’s tournament. Its key ESG weaknesses, reflected in its sub-scores, relate to political rights, civil liberties, the treatment of migrant workers and environmental risks, much of which has dominated the build-up to the 22nd World Cup. However, Qatar’s ESG data also has several strengths relating to rule of law, solid performance in reducing poverty and income inequality, low energy security risk, and in terms of social stability.
How does Qatar compare to previous hosts?
It is worth noting, however, that Qatar’s overall ESG scores are not much weaker relative to other hosts. Qatar is not much behind Argentina (hosts in 1978) or Brazil (who hosted the tournament in 1950 and 2014). South Africa have not qualified this time around, but were the hosts in 2010 and have roughly the same ESG scores as Qatar. Russia, of course, has seen its ESG scores plummet from what were similar levels to the current hosts since its invasion of Ukraine.
Perhaps the most surprising is comparison with Mexico, which hosted the Cup in 1970 and 1986 and will co-host the next with the US and Canada in 2026. Mexico’s ESG scores are lower than Qatar’s. This is largely driven by weaker scores for corruption, rule of law and judiciary, stability and peace; although Mexico’s trend has been improving.
There are many valid criticisms of Qatar hosting the 2022 tournament, but when ESG scores are compared Qatar’s numbers are not much worse, and in some cases comparable, to other hosts. Based on this small sample of host countries, it does appear that the criticism towards Qatar’s host status is not fully backed by its overall ESG profile.
This is a good example of the grey areas we find in ESG scoring and data, and a reminder that a nuanced approach and close examination of the sub-factors that constitute E, S and G, is warranted. Whilst Qatar may have a stronger overall ESG score than some peers, some sub-scoring factors (e.g. workers’ rights) and occasionally non-ESG related factors may become more important for investor perception than the overall ESG score. Brazil experienced it in 2019 with a global outrage about the alarming rise in Amazon deforestation, despite a very decent overall ESG score compared to developing nations.
And finally…
And finally, we checked to see who would win this World Cup if ESG scores decided matches. In such a final Switzerland would edge past Denmark to lift the cup!
[1] https://bondvigilantes.com/blog/2017/12/bvtv-world-cup-2018-the-dm-v-em-showdown/
https://bondvigilantes.com/blog/2014/04/world-cup-currency-trading-strategies-emerging-vs-developed-markets/
https://bondvigilantes.com/blog/2010/03/football-promotions-buffett-and-the-imf-world-cup/
Emerging market debt faced a difficult year in 2021. Will 2022 be any better?
The sovereign debt asset class delivered negative returns in 2021 – particularly local markets, which suffered from a double whammy of both currency depreciation and higher rates. Corporates fared better as the credit quality of the index is higher than the sovereign index, notwithstanding specific sectorial problems (e.g. China real estate).
Several factors that led to the poor performance of EM in 2021 may not be repeated in 2022, but there are still several drivers to be mindful of:
Source: M&G, Bloomberg (31 December 2021).
1) Inflation
A big surprise for 2021. A combination of demand-side recovery, fiscal stimulus, supply-side bottlenecks, labour shortages, currency depreciation in some cases and the very easy monetary stance of most central banks in the earlier part of the year led to inflationary pressures. Within emerging markets, Asia fared all right but most other countries did not. While the debate over how permanent this shock is rages on in developed markets (DM), we believe that it is more transitory in EM for the following reasons:
Expectations of tighter Fed policy have contributed to the outperformance of the dollar vs EM currencies and other major currencies in 2021. The better growth differential between DM and EM, as well as lacklustre capital flows into EM fixed income and broader EM assets were also drivers. In fact, many EM currencies depreciated vs the USD despite their central bank’s tightening and improved current account receipts (driven for example by higher commodity prices). This happened too before the Fed’s most recent tightening cycle. During that cycle, the EM local currency index posted negative returns for three years (2013-2015) during the taper period, but actually delivered a positive return in 2016 when the Fed started raising rates. It is a common misperception that EM FX fares poorly when the Fed tightens. In fact, they tend to depreciate in advance so that, by the time the Fed starts moving, they actually tend to perform relatively well.
Source: JP Morgan, 31 December 2021.
Additionally, most EM FX are fundamentally cheaper now than they were in that period (many were overvalued back then) and EM current account imbalances are far smaller – in many cases, they are actually in a surplus. For this reason we believe that, unless the Fed needs to hike by more than that which is reflected by the Fed’s recent dot plot estimates (three hikes for 2022, with hikes continuing into 2024), EM local markets should fare better in 2022. This is likely to be driven more by the currency side than by rates, as there is still very limited scope for rate cuts given the Fed’s tightening stance.
With less fiscal and monetary stimulus, inflation eroding purchasing power and the world still battling Covid-19 (Omicron now and possible other variants next), global growth is poised to slow in 2022. If anything, the projections below will probably be revised down in the coming months, once we have more information on the impact of Omicron. While a small headwind, we are far from a 2020-style recession. China will see a decline, but has started easing policy though RRR (reserve requirement ratio) cuts and – should it decide to do so – has scope to provide selective support to the real estate sector.
Source: M&G, IMF World Economic Outlook , October 2021 (latest data available).
The perennial wildcard. Potential flare-ups include Russia vs the West and Ukraine and more US-China tensions. These are low probability but high impact events which are not priced in. In terms of elections and scheduled events, Q4 will be particularly noteworthy. The China Party congress will take place in Q4, as will the midterm US elections. The most important EM election from a market standpoint will be Brazil in Q4, where there is scope to cater to a large centrist electorate that is not happy with the alternatives so far (Bolsonaro vs Lula). Latin America remains deeply divided in many countries and the administrations in Chile and Peru will need to navigate a delicate balance. In Turkey, it is unclear if Erdogan will call for early elections before 2023. The country’s ongoing departure from orthodox policies remains concerning, but fortunately it is not causing significant contagion across asset prices outside Turkey itself.
While sentiment towards EM debt was too bullish a year ago, it has now moved to the bearish camp, which could be a bullish sign in itself. Valuations have improved, particularly in EM local debt (FX and, to a lesser extent, rates) and select high yielders. Investment grade spreads, on the other hand, remain expensive and provide no cushion against higher US yields. Outside China HY, corporate defaults are expected to remain in their typical range as some deleveraging and/or liability management has taken place in 2021, commodity prices are higher and growth, even if it disappoints, is unlikely to cause a recession in 2022. Even within China real estate (which has seen a few defaults already with more to come) the contagion was rather small. If anything, China local markets were among the top performers in 2021 (CNY even appreciated vs the USD) on the back of strong current account and capital account restrictions. Local rates behaved as safe-assets as the bulk of holders are still domestic investors and so, with a backdrop of low inflation, they managed to outperform too. It is also quite remarkable that, despite the severe sell-off of the sector, the CEMBI corporate index posted a positive return in 2021, reflecting its well-diversified composition in terms of countries and sectors, and with an investment grade average credit rating. Sovereign debt restructurings could include Sri Lanka, El Salvador and Ethiopia, but none is systemic enough to cause contagion.
Conclusion Overall we are less worried about EM inflation in 2022, and selectively bullish on EM currencies with strong external accounts or where inflation may soon be peaking. Despite being more cautious on growth, we favour HY vs IG but recognize the tail risks within this segment – as always, differentiation is key. In 2021 for example, we saw -30% returns for El Salvador and Ethiopia and even worse within the China property space, but distressed credits may also surprise on the upside, like Zambia (+50%). Our bias is to add local exposure and tactically manage the HY component by bottom-up country and credit selection and position sizing.
Summary: Following our blog on Sustainable bonds and the case of Benin, this time we focus on Blue bonds and Belize. Belize recently announced a tender offer for its existing $553 million Eurobond due in 2034, which will be financed by the concurrent placement of a Blue bond as part of the Nature Conservancy Blue Bond Ocean Conservation Programme.
The Blue bond concept aims to use debt proceeds to finance water-related and/or ocean-based projects with an evident and monitored positive impact towards the achievement of the UN Sustainable Development Goals. It has already been used by a few emerging market issuers, but not as widely as have Green bonds.
One relevant case study was the $15 million 10 year bond placement in 2018 by Seychelles. That bond was issued as part of a broader debt relief that included the Paris Club and was the first Blue bond issued by a sovereign entity. At the time, Seychelles was rated BB- by Fitch and had a non-disbursing agreement with the IMF, underpinning its commitment towards improving economic policies. The principal is partially guaranteed by the World Bank and carries a 6.5% coupon. Seychelles was subsequently upgraded to BB, but has since been downgraded to B on the back of the impact of the pandemic on tourism and the broader economy.
The Belizean economy was also heavily impacted by the decline in tourism revenues seen in 2020, which triggered a large contraction and fiscal deficit.
Source: IMF April 2021, M&G calculations – data do not reflect any debt reductions as a result of the bond tender. Future years are forecast.
Source: IMF April 2021, M&G calculations – data do not reflect any debt reductions as a result of the bond tender. Future years are forecast.
Belize’s tender envisions a 45% haircut on the currently outstanding principal, which would reduce the country’s debt by approximately 9% of GDP. Belize has also pledged to pre-fund a $23.4 million account to support marine conservation projects. The authorities are proposing fiscal consolidation on its upcoming budget, but absent a steadfast implementation and a cyclical recovery, debt levels will stay high as the remaining debt (multilateral, bilateral and domestic) is not expected to be restructured. Since its inaugural debut bond in 2000, when the country was in the BB range, Belize has restructured its Eurobond four times – on average once every five years. Despite these frequent Eurobond restructurings, Belize has not managed to reduce its debt burden as growth has been low and expenditures elevated, leading to persistent primary deficits.
The details of the Blue bond have not yet been announced, so we do not know if there will be additional principal or coupon guarantees provided besides political risk insurance provided by the US International Development Finance Corporation.
We welcome this innovative approach and are hopeful that bondholders and issuers continue to increase collaboration towards the sustainability of our ocean resources and improving ESG credentials more broadly. At the same time, good ESG intentions cannot replace prudent economic management and willingness to pay. If history repeats itself – and we hope it will not here – the upcoming Blue bond may well see itself restructured once or twice over its tenor. If that occurs, though from a blue start, investors will be seeing red again.
Summary: Benin recently issued its first Sustainable bond (SDG), also the first for a Sub-Saharan issuer. The net proceeds of the €500 million issue will be used to fund expenditures in pre-determined categories, including agriculture, water, health, housing, education, low-carbon energy, biodiversity and others. An annual disclosure of the disbursements is expected and the framework has received a second party opinion which deemed it in line with best practices.
The pricing, 4.95% coupon or +511 bps over swaps, was roughly in line with Benin’s last issuance in January.
Growth declined to 2% last year as a result of the pandemic and the border closure with Nigeria, but it is expected to rebound to 5% this year. Like in many emerging markets countries, that led to a fiscal deterioration, which is expected to normalize as the economy recovers. Living standards, which had previously been improving, suffered a setback. Benin has been able to finance the deficit by a combination of financing from the IMF, World Bank, EU grants, domestic financing and the external bond markets. It decided not to participate in the G20 Debt Suspension initiative.
Benin’s debt burden, which is at around 47% of GDP, is not large. In fact, it has optically fallen after the country rebased its economy. [1] However, a large informal economy and low income, results in a low revenue base (14% of GDP). Consequently, Benin cannot carry as much debt as countries that benefit from a much larger revenue base. It also has very limited room for monetary policy, being part of the West Africa currency regime, whose other members have also seen their financing needs increase at the same time. Until its debut in the bond market in 2019, Benin’s debt stock had been mostly concessionary at low interest rates. Since then, its external bond coupons have ranged from 4.875-6.875%. Benin is a small economy at around $16 billion so the SDG bond translated to 3.7% of its GDP.
As a result of the debt increase, but also a larger share of costlier market debt, its interest payments as a percentage of revenue has quadrupled since 2015.
Source: IMF April 2021. Estimates from 2020 onwards
This trend, ironically, may have a reverse social impact as the higher the interest spending, the lower the room for other types of spending (for the same level of deficit), including general budgetary purposes or other types of expenditures that do not explicitly fall under the SDG framework, but could still have a social impact (e.g. public sector wages, pensions and transfers).
The IMF deems Benin’s debt as sustainable, but has warned that its risks have increased. The SDG bond ranks pari passu with Benin’s other external bonds and we do not expect it to fare necessarily better in the event of a restructuring.
For now, we concur that Benin’s debt, including its sustainable bond, is sustainable. We continue to monitor closely both ESG factors along with overall macroeconomic and political factors as part of our fundamental assessment of the countries we cover. However, should growth be materially below forecasts for the next few years or revenues do not start increasing, there is a material risk that this sustainable bond becomes unsustainable.
[1] For more details on the rebasing, please refer to Eldar Vakhitov’s blog: https://bondvigilantes.com/blog/2021/12/19/investors-care-gdp-data-revisions-emerging-markets-benin-case-study/
By Claudia Calich, Gregory Smith and Eldar Vakhitov
Market expectations of global oil prices have shifted several times already in 2020. The year started with short-lived scenarios of potentially higher prices, as tensions between the USA and Iran dominated the headlines. However, as COVID-19 tragically spread, the virus put a clear dent into expectations about global growth. Curfews and efforts needed to contain the virus’ spread hit both demand and supply. First in China, then globally as the virus spread. Expectations about oil prices softened accordingly, with Brent dropping from $60/bbl in late January to close to $50/bbl in early March. At this point, emerging markets were feeling the pressure of slower growth prospects and weaker sentiment as global stock markets sold-off. But there was a much bigger oil move to come.
Saudi Arabia had over the past two years agreed with Russia, and several other non-OPEC producers, to limit production in order to keep oil prices in a range broadly between $50/bbl and $70/bbl. At an OPEC plus meeting on 06 March, Saudi had hoped to secure agreement from Russia, and other oil producers, to make new commitments to hold back on supply. Saudi Arabia had not wanted to do all the heavy-lifting alone. But Russia decided not to support the cuts, and overnight the landscape shifted 180 degrees. Saudi Arabia gave up on the cuts and pledged lower prices and a greater supply of oil. This sent oil prices tumbling down to the mid-30s when markets opened on 09 March.
Brand new scenarios for oil prices were sketched out for 2020 and 2021 by the markets. They had to gauge not only the potential impacts of COVID-19, but also now an oil price war. One scenario involves Saudi’s move provoking Russia to change its stance and agree on cuts, lifting oil prices in the process. But this was not the prevailing view. Instead the idea that oil prices might remain in the 30s over 2020 dominated market thinking.
Emerging markets tend to feel strain when global oil prices drop. There is a clear impact on the oil producers. Meanwhile, oil-importers might see some balance of payments pressures easing. However, they also tend to face higher costs of borrowing and the effects of weaker market sentiment. Furthermore, oil importers are more likely to be tourist destinations than oil producers. Hence they are braced for lower FX earnings as COVID-19 travel restrictions limit visitor numbers.
For the oil producers a move of this magnitude requires adjustment, with oil prices as much as $20/bbl below the level on which 2020 budgets were calibrated. Countries with large balance sheets, flush with saved financial assets, look stronger than those without such assets. For others with a weaker balance sheet, it is a matter of how long FX reserves will last at different extents of fiscal and external adjustment. Countries with pegged currencies are likely to need more FX reserves, than those who can adjust their exchange rates. We examine four emerging markets and discuss the impacts of potentially lower oil prices.
Ecuador
Ecuador is one of the most vulnerable countries to a decline in oil prices. As a dollarized economy, it does not have the flexibility of the exchange rate as an adjustment valve. Furthermore, although its debt levels are lower that some other oil exporters (Angola for example), it already had a large fiscal deficit even before oil prices collapsed. While the Moreno administration has had good intentions, complex domestic political dynamics ahead of a 2021 election, with the risk of populist policies returning, have made large fiscal adjustments difficult. The IMF has been very supportive thus far, but the new reality of oil prices mean that the programme assumptions will need to be re-calibrated, and future disbursements may not happen under the original schedule or at all. Should oil prices remain in the 30s for an extended period of time, Ecuador will run into a liquidity crisis. In this uncertain environment, any other potential sources of liquidity (upcoming asset sales, additional funding from China, etc) may not materialize. Ecuador has been one of the worst performers over the last week and the bonds are now pricing a very likely re-structuring in the next 12 months. Should that happen, it would be the country’s third in the last 20 years.
Saudi Arabia
Saudi Arabia’s economy is dominated by oil production. As its riyal has been pegged to the US dollar for decades at the same rate, the government is unlikely to adjust it. But the Saudi Arabia Monetary Authority has amassed a huge amount of reserves, worth close to $500 billion in 2019 (62 percent of GDP). Oil averaging $40/bbl in 2020 could double Saudi Arabia’s fiscal deficit if budget plans are not cut and put the external account under pressure as the current account breakeven oil price is around $50/bbl. Saudi Arabia is a low cost oil producer and its accumulated buffer will help it to weather the storm and maintain its peg. But in the absence of exchange rate adjustment, FX reserves could halve if oil prices remained low until the end of 2021.
Nigeria
Nigeria, along with Angola, faces the largest potential adjustment in the African eurobond space. The Central bank of Nigeria (CBN) has kept the Naira pegged to the US dollar since the last devaluations in 2016 and 2017. The exchange-rate stability has been welcome in 2018 and 2019, enticing foreign investor demand for Nigerian short-term domestic debt. But the big drop in oil prices might put too much pressure on FX reserves—that had already been falling steadily since June 2019—if the CBN tried to maintain the currency status quo. The option of devaluation, in response to lower oil prices, is available to the authorities in 2020 as a means of adjustment. Meanwhile the government has stated its intention to re-work the 2020 budget which was based on $57/bbl.
Russia
Russia’s progress towards economic diversification has been limited in recent years, but an impressive fiscal adjustment has been implemented. The breakeven oil price for the budget fell dramatically to about $45/bbl in 2019 (from $110/bbl in 2013). A budgetary rule has kept discipline, ensuring oil revenues above $42/bbl have accumulated in the National Welfare Fund. This oil fund has reached $170bn (10% of GDP). Government debt is also very low at close to 15% of GDP. Furthermore, in contrast to most oil exporters, Russia has opted for a flexible exchange regime which provides an important avenue of adjustment to lower oil prices. Moves in the Ruble, plus FX reserves worth 18 months’ of import cover, underpin Russia’s resilience which already passed tests when it brushed-off increased US sanctions in 2018.
If Saudi Arabia’s plan is to pressure Russia into a new agreement for oil production cuts, a glance at Russia’s balance sheet suggests it might take a long time, and might end up hurting Saudi Arabia more. In any case, the greatest pressures of lower prices in 2020 would fall on the higher cost oil producers, many of which are in the US.
If a scenario of oil under $40/bbl plays out in 2020, the landscape for the EMBI diversified index oil producers will change massively. The inclusion of the GCC countries in 2019 has shifted the index’s weighting to oil producers from just under 30 percent in 2018 to 37 percent in 2020. If oil prices stick at current levels, 2020 budgets will need to be torn up and redrawn. The necessary adjustment will be substantial, with the countries with better balance sheets and adjustment tools much better placed to weather the storm of lower oil prices, all while grappling with the global impacts of COVID-19.
2019 proved to be a spectacular year for returns in most asset classes and emerging market debt was no exception. Returns were driven by a combination of cheaper valuations to begin with and also helped by the market-wide U-turn in going from pricing in Fed hikes to cuts and by the subsequent US rate rally. Some key risks were also priced out as the year moved on, including the US-China trade war after the Phase 1 deal was announced.
Asset allocation between hard, local and corporate debt was not a major call in 2019
The key call in 2019 was to be long most assets and avoid the large tails, particularly Argentina and Lebanon which had a combined index weight of over 5%. This makes 2019 one of the years with the largest percentage of assets heading into a restructuring since 2001, when Argentina entered its last restructuring.
Differentiation of performance between countries and also within countries
Despite the high level of debt becoming distressed in 2019, it is encouraging that markets (correctly) treated both sell-offs as being idiosyncratic, not systemic. The correlation between Argentina and Brazil spreads, for example, was much lower this time around than in the early 2000s. The asset class is much more diversified than it was in the early 2000s: there are almost 80 countries represented now, while there were fewer than 20 then. Many countries, Brazil included, also managed to improve their debt profiles by funding more in their local currency instead of via external debt. This increased resilience and has helped to lower contagion risk.
It was also reassuring to note that, even within single countries, there were large differences between individual credits. For example, while Argentinean corporates underperformed somewhat, they still returned a not-too-shabby 8.4% in 2019 despite the unfavourable macro environment. Investors have been able to differentiate credits, including the ones that have lower leverage and foreign exchange earnings.
Similar divergences in outcome were also seen in local currency bonds where, for example, contagion from the depreciation of the Argentinean Peso only mildly impacted Uruguay, an economy which has strong trade and economic links with its neighbour.
Outlook for 2020
The stellar returns produced in 2019 are unlikely to be replicated in 2020. This is mainly since starting valuations, particularly in spreads but also in local rates, are less favourable than those which we had a year ago.
Below are three scenarios of potential returns. Of course, there are several assumptions that need to be made here. The below scenarios assume parallel spread or yield shifts and include the initial carry but not the difference in yield movements through the year.
Scenario A: Unchanged
The unchanged scenario (which almost never happens in EM) outlines potential returns should everything be constant: essentially returns based only on carry and with no currency movements versus the US dollar.
Scenario B: Bullish
A bullish scenario would reflect a supportive macro environment with growth improving in many EM economies, the US slowing only mildly, continued easy monetary conditions by developed market central banks and no worsening of global geopolitical risks – of which there are plenty. Read Charles’ recent blog for a sample of some potential geopolitical risks for EMD investors to watch in 2020.
Scenario C: Bearish
A bearish scenario would reflect a more challenging macro environment, with global and EM growth slowing further, or a scenario of less accommodative policy by global central banks and rising inflation, a worsening of geopolitical risks or policy mistakes in various economies.
Given that few EM central banks are likely to continue cutting rates this year, currencies rather than rates will likely be the key driver of returns in all scenarios. Most EM and DM central banks are also now done with or close to ending the monetary easing cycle, so there is much less scope for a rally on local rates.
Despite favourable valuations of EM currencies (in absolute terms but also relative to external debt), I remain neutral overall in terms of asset allocation given the uncertainty of the various geopolitical risks and potential impact on the US dollar. Similarly to my view in 2019, I do not expect asset allocation to be a major driver of outperformance but rather a directional call on the markets and, to a lesser extent, specific countries and managing tail-risks appropriately.
Key country calls will be centred around the higher yielders such as Argentina, in which we moved last month from neutral to small overweight after the sell-off, expecting a higher recovery value than current prices (low to mid 40s) and a restructuring being completed in 2020. Other likely candidates include Ecuador and select frontier countries such as Sri Lanka, Ghana or Ivory Coast.
As a consolation, while EM debt may not look cheap when compared to prevailing valuations a year ago, most other asset classes (equities, US high yield) have also rallied materially. So on a relative basis, maintaining exposure to the asset class may still look like an attractive proposition for its income in an environment of still low yielding assets elsewhere.
Last night, the US Treasury designated China as a currency manipulator. This has occurred a few times in the past, most recently in 1994. Though China has been on the Treasury’s watch list for some time (alongside several other countries), given that the most recent Treasury report published in May did not name China a manipulator, it begs the question, what has changed between then and now?
The criteria is based on the chart below. One of the issues with the criteria is that it focuses on the largest bilateral trade deficits in nominal terms. Arguably, this reduces the need to monitor bilateral imbalances for economies that are much smaller in size, where the surplus may be large (as a percentage of the economy) but small in nominal terms. One example is Israel, a small economy that posted a larger surplus, as a percentage of its GDP, than several other countries on the monitoring list (see our prior blog) This also means that a small open economy like Thailand would fall just below the $20 billion arbitrary threshold, but India, a larger closed economy would just exceed the threshold.
According to the Treasury’s most recent estimates below (China does not publish that data), China has not materially intervened in the currency for a large part of the last year. If anything, it was selling USD reserves to prevent a faster depreciation in 2015-2016, when it further tightened capital controls. Based on PBoC data, we do not believe it has materially intervened to weaken its currency since then. The Renminbi has however now crossed the 7 rubicon.
The US Treasury believes that China’s reserves are ‘above standard measures of reserve adequacy’. That may be true for a country that has capital controls, but as China aims to gradually open up its capital account, the level does not seem to be excessive. Reserves have been relatively stable since 2017 at $3.1 trillion, so the IMF’s calculations below are still valid.
From the criteria described above, it appears that nothing is likely to have changed since May, except that the trade war between both countries has intensified. China has been running large bilateral trade surpluses with the US for some time and the US allegations of protectionism and state subsidies are warranted, but nothing new.
Following the recent US announcement that they will impose 10% tariffs on an additional $300 billion of Chinese goods, the PBoC allowed the Renminbi to depreciate past the closely-watched 7 level, but the depreciation was roughly in line with other Asian currencies. If anything, the Renminbi had, until recently, depreciated less than neighbouring currencies, which is something that the PBoC monitors closely when setting its daily fixing.
The bottom line? The data alone does not justify why China was designated a manipulator now, as opposed to May or October, when the next Treasury report is set to be published. The trade war continues to escalate and the timing is much more related to that, than what the data indicates. This is not over. Stay tuned.