Emerging markets stand up to the test
The outlook for emerging market debt is good, despite predictions of further raises in US interest rates.
By Sudip Roy
It's a sign of the increasing maturity of emerging markets that investors and bankers are upbeat, despite the fact that US interest rates are on an upward trend. Usually, when the Federal Reserve enters a tightening cycle, it spells disaster for the asset class. Both in the late 1980s and in 1994, the emerging markets spiralled into crisis triggered by a suffocating increase in US rates.
This time the situation appears to be different. The asset class has more than held its own. The JP Morgan EMBI+ is up 3% and could reach 7% returns by the end of the year, according to some analysts who are becoming more sanguine. ?The emerging markets debt rally is four months old, and continues to be fed by evidence that the economies of Europe, Japan and the US are slowing down, thus reducing concerns about higher interest rates in the OECD world and a potentially hostile global environment for the emerging markets,? says a recent strategy report by ABN Amro.
Investors, who in April and early May were initially scared off by the change in the Fed's stance, are now returning to the asset class. Dedicated emerging markets bond funds posted net inflows for the fourth week running at the beginning of September, as fears about the pace and scope of US interest rate hikes continue to moderate, according to Emerging Portfolio Fund Research. Overall, funds have posted collective net inflows of $428 million since the beginning of the year.
?Recent economic data continue to reinforce expectations of positive economic growth and a gradual tightening of interest rates,? says Brad Durham, a managing director at the firm, which tracks 249 emerging markets funds. ?With downward pressure on US bond yields, investors have been gravitating to higher yielding emerging markets debt, while the belief in gradual tightening is allowing some investors to continue borrowing at the short end to invest in emerging market bonds.?
Latin strength
Underpinning the good vibe are strong economic fundamentals. Take Latin America, for example. Once derided as one of the worst performing regions, Latin America is quietly outstripping the rest of the world, according to Walter Molano, head of research at BCP Securities in Connecticut. ?The macroeconomic data in Latin America has not been this good for decades,? he says. ?Moreover, Latin America's expansion is being achieved in an environment of price and monetary stability as well as fiscal discipline.?
Most Latin American governments are raising their 2004 growth forecasts. The region's economies should grow about 3.8% year-on-year in 2004, against a rate of 1.1% last year, says Molano. Inflation is also under control ? the rate should drop to 6.8% this year compared to 7.2% in 2003. ?Despite the improvement in economic conditions, most governments continue to pursue prudent fiscal policies,? says Molano. ?Most countries are on or ahead of their fiscal targets.?
All of this is feeding through to the performances of some of the region's leading credits. Brazil, for example, was upgraded in September by Moody's Investors Service. The sovereign's long-term foreign currency rating was upped to B1 from B2, leaving it four levels below investment grade. S&P also upgraded Brazil last month to BB-. ?Brazil is an excellent credit,? says Jerome Booth, head of research at Ashmore Investment Management. ?We have seen a resurgence of growth after a prolonged recession.? Brazilian bonds have rallied sharply since the big sell-off in April and May. The yield spread on Brazil's government benchmark 10-year dollar bond has halved to 400bp above US Treasuries (as of mid-September).
Another Latin credit on the up is Venezuela, now that the country's political situation is more stable following President Hugo Chavez' victory in a referendum. In September, Moody's upgraded the sovereign by two notches to B2, largely on the back of the high oil price, Venezuela's principal revenue earner. Investors have responded in kind. According to Emerging Portfolio Fund Research, Venezuela's weighting in its index of tracked funds is about 6% compared to 3.6% in August 2003.
Asia
It's not just Latin America that's attracting money. Countries in other emerging regions such as Turkey, South Africa and even the Philippines are on investors' radar screens. Asian credits, for example, are seeing money flows from investors all around the world. ?Regional liquidity is still evident, but it's not as great as it was at the beginning of the year,? says Rahul Mookerjee, head of Asia debt capital markets at Deutsche Bank. ?Now we are seeing relatively greater participation from US and European investors.?
Mookerjee says that non-Asian investors are becoming more accepting of primary issuance spreads. A number of recent deals, such as Indian bank ICICI's $300 million, five-year bond, are seeing offshore US accounts taking a third or more of the paper on offer. In the past, according to Mookerjee, these funds typically bought 20% to 25% of the book.
Risk factors
With a more benevolent global environment and strong fundamentals, what are the main risks? The biggest remains a short-term external shock. If US interest rates were to jump suddenly for whatever reason, then emerging markets would be the first to feel the impact ? and not just because their borrowing and debt servicing costs would rise.
Many credits would be hit by the withdrawal of short-term investors, such as hedge funds, who tend to react quickly to non-emerging markets events. These investors are becoming more influential in the asset class, and while that can be a healthy sign when things are good, their ability to drop out when the situation deteriorates means emerging markets are still vulnerable to great volatility. This was amply demonstrated between April 7 and August 4, when the funds tracked by Emerging Portfolio Fund Research posted net outflows in 15 out of 17 weeks as investors pulled out $1.22 billion.
The best way for investors to approach the asset class is to be more selective, according to Mohamed El-Erian, managing director at Pimco, the world's biggest emerging markets fixed-income investor. ?Emerging markets exposure should not be index driven in an automatic manner; it should seek to exploit country-specific differences in outlooks for economic and financial variables,? he says.
Overall, though, the outlook for emerging markets is more positive than at any time since the first quarter. As ABN Amro's research note says: ?While heavy new issuance activity during September to November may have some impact on emerging market bond prices and spreads, we are optimistic that the upbeat trend will not be derailed.?