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3rd December | Dubai
We interacted with Koon Chow, EM Macro and FX Strategist at UBP around his views on the continued improvement in Emerging Market fundamentals, EM corporate bonds, the US interest rates amongst other issues.
Could you share some light on your view of macro fundamentals globally in particularly the EM?
We have a constructive view on EM economic fundamentals with EM GDP growth likely to accelerate from around 4.7% in 2017 to 5.0% in 2018. This upswing is the result of stronger world demand for commodities and capital goods, reflecting increasing global business confidence fostered by an especially strong Euro Area acceleration and a continuing robust US economy. Any boost in global demand for commodities and capital goods is particularly important for EM because a significant part of their economies are commodity and manufacturing-focused exporters. This contrasts with a couple of years ago when global demand for consumer goods and services largely bypassed EM economies. This externally driven upswing supports EM business confidence, employment trends and increasingly, EM consumer spending. This last element looks set to show the largest marginal improvement in 2018 relative to other sectors of activity. EM policymakers had a mixed track record on reform measures in 2017. The ones that stick out, as having worked hard to implement reform include India, Indonesia, Mexico, Argentina and (to a lesser degree) Brazil. There are other major economies including South Africa and Turkey where there has been little in the way of reform and where economic problems are deepening.
Any specific EM’s that you are focused on and expected to see continued traction going forward?
Argentina is likely to remain attractive to investors as the government tries to make further progress with its reform programme, notably in lowering inflation with responsible monetary policy and curbing payroll and subsidy-related government spending. These changes, if continued, should help to lower macroeconomic uncertainty and in the long term, lower the real funding costs that face both government and the private sector. Higher resulting investment should boost returns on most Argentine assets.
Indonesia is another interesting case, with one of the fastest rates of GDP growth in 2017 (5%+) and unrealised potential from higher transport infrastructure investment. For many years, Indonesia’s structural problem has been the absence of sufficient transport infrastructure investment, which the current government is trying to remedy by re-prioritising its spending from subsidy giveaways to more direct public building works. The last two years have seen this infrastructure spending ramp up, which if continued could also boost GDP growth in Indonesia to an even higher level. The current president remains popular, which suggests that the 2019 elections could return him to power and so deepen the reforms in the country.
And moving into a little bit more specific, how’s this change in macro fundamentals trickling down to the corporate sector?
A strengthening of GDP growth will generally be helpful for the EM corporate sector by boosting both their revenue growth (seen already) and, with a lag, profit margins as well. These margins have not (with the exception of the materials and mining sectors) improved across EM. Into 2018, it seems likely that the trickle down benefits of the macro improvements will become more visible, which in turn should help further compress EM corporate bond spreads over US treasury yields. However, it is important to be more watchful for differentiation in corporate bond performance as US treasury yields are unlikely to stay down here. Moreover global QE – another component of funding costs – is likely to be less generous than in 2017. To put it another way, global funding costs are set to increase a little bit which could hurt highly-leveraged companies or low yielding commercial bonds.
The bond market in the GCC region has been particularly active particularly on the sovereign side. What is your take on the overall fundamentals and do you expect more participation from the corporate spaced in the fixed income market?
There is a need for caution due to the supply side in the bond markets in the GCC. Although governments in the GCC are trying to cut expenditure while their revenue has gained from higher oil prices, budget deficits remain large. Saudi Arabia, for example, is likely to have a budget deficit of around 9% of GDP in 2017 and it could also be fairly substantial in 2018. These large budget deficits will need financing and this will underpin ample sovereign bond supply. Along with the issuance needs of GCC corporates, this means a lot of bonds on the market in 2018. Meanwhile, there are always other corporate bond markets where yields are high potentially drawing global investors’ attentions away from the GCC.
What are the key facilitators you expect to continue to drive interest in the Emerging Fixed income market?
There are two key main drivers of interest in Emerging Fixed income markets: 1. Low yields in developed markets; 2. A structural re-balancing of portfolios into EM. Global government bond yields in developed markets are still on average only around 1.5%. This is likely to rise only gradually over time but not quickly enough to stop global investors from looking around for other fixed income markets to invest in. The ‘push motive’ for investment is powerful and at this point, is complemented by the ‘pull’ of improving EM economic fundamentals, notably rising GDP growth. This improvement in GDP growth typically means some support for the ability to repay both sovereign issuers (higher GDP growth means higher taxes) and corporate issuers (higher GDP growth typically correlates with higher corporate revenue and profit margins). Global investors also have a structural motive for putting money into EM fixed income markets as their exposure to them is still quite low. According to the IIF, global bond portfolios only had around 10% of their exposure in EM as of mid 2017. This is close to the multiyear average and arguably the ratio should be higher because of EM’s relative high yield levels and their increasing footprint in many different economic areas (e.g. share of global GDP).
EM corporate bonds are expected to continue to have strong risk adjusted performance against say Developed market bonds. Could you explain the rationale behind this?
EM corporates have some inbuilt advantages which help risk adjusted returns during a generally positive trend across the global credit market. The advantages are specifically: 1. Higher yields than similarly rate corporates in Developed Markets (DM). 2. EM markets have greater diversity than DM by virtue of there being more countries classified as EM compared to DM. 3. EM sovereign and corporate bonds had a difficult period between 2014 and 2016, which probably means that global investors are still cautiously positioned in them. By comparison, DM corporate bonds – especially from the US – have had a positive economic backdrop over that period, which probably enticed more investor flows into them i.e. DM market corporate bonds technicals may not be as attractive to investors as EM corporate bonds.
Whats your take on the US interest rate cycle and how do you perceive the risk of a rise in rates? And how do investors position themselves with such an event in mind?
There is a clear expectation of the Fed hiking interest rates again in December of this year and into 2018 as well. In addition, the Fed will continue to take steps to shrink its balance sheet, on a net basis divesting itself of some of its Treasuries that it bought during the QE period of the past. These factors combined are likely to give a moderate push up to US treasury yields taking the 10 year yield to around 2.70% from the current (going to press) of 2.35-2.40%. Investors, mindful of this risk, would be wise to position themselves in higher yielding corporate and sovereign bonds and, if possible, short duration instruments to desensitise their portfolios from US treasury yield swings. Such a strategy has advantages as in periods when US growth has been strong and US treasury yields rose, EM sovereign and corporate eurobonds – especially the higher yielding ones – have still delivered a positive performance. This pattern supports a strategy of being actively engaged in EM bonds.