EM debt outperforms expectations
Jean-Jacques Durand, manager of the Edmond de Rothschild Emerging Bonds fund has been interviewed about the performance of emerging market debt, interesting EM debt opportunities and the risks facing fixed income investors
At the beginning of 2014, most investors were cautious on emerging debt. Has the market proved them right?
Contrary to expectations, the emerging debt market has risen sharply since the beginning of the year. The JPM EMBI Global Hedged (EUR) index is up 7.9% so far this year (to 20 October).
Unlike the consensus, we had been rather positive on emerging debt since last autumn as we found valuations attractive and technical factors generally favourable. That is why we chose to reduce our cash position and gradually take on more risk. We saw the market advancing by 5-10% in 2014 so it has so far performed better than we expected.
There are two main reasons for this: first, lower US yields as the recovery stalled in the first half, support from the Fed and persistently tame inflation. Second, attractive spreads on emerging debt and favourable investor positioning. And yet there were numerous areas of concern that could have had negative consequences and stopped markets rising, notably political risk from elections in emerging countries and geopolitical risk in Ukraine, Iraq and the Middle East. These risks are still present but markets have proved robust thanks mainly to technical factors.
Many investors underestimated the potential returns from emerging debt and volumes remained relatively modest.
The overall market still has upside for the rest of 2014 but any further advance could well be limited after the rises seen in recent months. Net issuance of sovereign debt should decline, a positive factor per se, but some valuations are now less attractive. We believe that the sort of non-benchmarked active management deployed by Edmond de Rothschild Emerging Bonds is geared to the current environment. The long term trend on these markets is favourable and there are still opportunities, regardless of the environment. Every year, outperformance in the emerging debt segment hinges on a few specific stories or themes. These are the sort of factors we seek to identify.
Where are the most interesting investment opportunities nowadays?
Despite the high volatility, Venezuela has reached interesting technical levels (positioning and valuation). They benefit from different international sources to pay coupon and they need to keep an access to the financial markets. That’s why they can’t take the risk to be in default. Moreover, they have the ability to ajust many variables to increase debt service capacity through FX system, oil delivreries to China and Central America and energy subsidies.
Another interesting story is about Ukraine and Russia conflict. Indeed, the conflict appears to have stabilized and a cease fire seems to be holding. It is likely that Ukraine and the world will have to live with this frozen situation for a while as Russia will keep using it’s nuisance capacity. Then, regarding Ukraine economy, it benefits from huge financial support from the IMF, Europe and the US.
Actually, the main region within our portfolio is Europe area with Ukraine and Russia exposure. We have also an interest in Turkey. The country benefits from a diversified economy (sector-wise but also geographical) and FDI. Since 2003, the current president Erdogan has strongly decreased the debt/GDP ratio. Then, market positioning and TRY are more attractive.
What is the biggest risk fixed income investors are currently facing?
The two main risks are the increase of US interest rate and the Chinese growth. For us, the second is more dangerous than the first. Indeed, expectations about global growth, European and US situations, allow us to think that the FED adjustment will be gradual with a step by step move which is positive for our market. Then, following the recent readjustment, current EM valuations are much more attractive and the market positioning is more favorable. We think that Treasury’s risks have been largely priced by the market.
About Chinese growth, we see some potential risk with real estate sector, credit growth or the difficulty to switch from a manufacturing to consumption economy… Regarding real estate sector, it contributes for 10% of the GDP. If we add all the satellites around this sector, it contributes for about 20%. I let you think about the risk if prices continue their slowdown trend. * Past figures refer to previous years and are not a reliable indication of future returns.