Emerging Markets: Not a Broad-Based Contagion, says Pioneer’s Syzdykov

Yerlan Syzdykov, head of Emerging Markets – Bond & Yield, Pioneer Investments answers a Q&A on emerging market corporate bonds in risk-averse times.

What are the reasons behind the renewed turbulence of Emerging Markets (EM)?
A combination of global and regional factors may be behind the current sell-off, notably involving EM bond markets. The main global factor is the US Federal Reserve’s tapering of monetary stimulus, long announced and now early in progress. The Fed wanted to be reassuring about the pace of tapering, which is unlikely to accelerate if domestic economic data are not overly strong. The latest labor market report was actually on the soft side of expectations. However, most investors embracing the EM market in search of additional yields have already shown disappointment at evidence of an economic slowdown, which put some downward pressure on local currencies. The prospected end of cheap money – the main “engine” of the search for yields, came alongside rising concerns for the “fragile fives” – South Africa, Turkey, India, Indonesia, Brazil – and their ability to finance growth with foreign investments. Investors were probably not adequately prepared for country-specific fundamentals to move markets again.

What are the main country-specific issues?
There are a number of critical situations worth assessing. Turkey, with a current account deficit above 7.4%, is strongly reliant on external flows. The Central Bank has just raised all its main interest rates at an emergency meeting in an effort to halt the currency run triggered by the recent political turmoil and concerns on the country’s vulnerability.

The action taken overnight is a step to restore credibility of the Central Bank in managing monetary policy effectively, keeping inflation rate under control. Similar actions have been taken in India, South Africa and in Brazil, which raised interest rates for six meetings in a row. Argentina, with few reserves left to defend the currency, opted for a massive devaluation, and we believe that stability will be hard to restore for the peso. For its part, China should be in a better position but it, too, sparked some concerns about the health of the financial sector on reports that a trust fund (part of the “shadow” banking sector) was defaulting.

The prospected bailout may save the day but is unlikely to provide a lasting relief as it does not dispel the threat of other similar incidents. Last but not least, there has been an increased supply of new issues weighing on the market just as investor’ risk appetite fell. Given all these factors, investors are asking for higher risk premiums and we can’t rule out that a repricing of the asset class may continue in the coming months.

Do you believe an extended correction will lead to a contagion?
We do not believe that this price correction will result in a broad-based contagion like in past times, as the EM landscape is now far from uniform. In the medium term, we believe the market will reward countries with solid external positions starting from China which accounts for a large part of EM GDP and is also a very high-profile investment case as we know.

Then we should apply a thorough selection process and find countries which have sound economic policies in place, (some Eastern Europe countries for example), but may be indiscriminately hurt by a risk-averse scenario. However, in the short term, it’s hard to see the market focusing on fundamentals so I’m afraid we expect volatility to stay high especially on currencies. This may create some buying opportunities, for active risk-takers, on a medium term horizon.

You named China for its high-profile role. Are there any reasons to feel concerned instead?
The reaction to the latest data is so far indicative of the challenging climate, as the most relevant reports were in line with expectations, starting with Q4 GDP growth. We should always acknowledge that China is in a transition phase and the change to a consumer-driven economy is consistent with a slower pace of growth.

Countries which are more exposed to China’s growth are likely to suffer during the delicate transition, but those selling consumer goods should benefit in the medium term. The new leadership’s commitment to reforms, if successful as we believe, makes for an accelerated path to structural changes which may restore confidence in EM as a whole.

May the corporate sector be a defensive option in the EM bond universe?
So far it has been. In the last sell-off, the widening of spreads was more pronounced in the sovereign sector than in the corporate sector. Within corporates, investment grade outperformed high yields as the risk aversion surged. Year to date[1], the index for external sovereigns recorded a negative total return of 0.17%, while the corporate index recorded a positive 0.59% (IG +0.77%, HY +0.19%). We believe that the credit market will continue to offer opportunities on a selective basis looking for solid fundamentals and sectors like energy, which could benefit from recovery in developed markets.

What are the odds of a contagion on global rates?
Risk aversion often hits credit markets at large but only when the crisis of confidence was very widespread. In that case, investors may be gripped by renewed fears of recession and deflation and would find nothing better than seeking refuge in German Bunds and US Treasuries. As we said, we believe that the risks of contagion are limited as things stand, but the possibility of overshooting is always worth considering. For our part, we feel the need to be particularly selective in these circumstances and although we concede that it’s hard to be rewarded by one’s selection skills in moments like these, we’re committed to set a more defensive asset allocation.

What may avoid this worst-case scenario if this occurs?
The most involved EM policy-makers are making efforts to sort things out and avoid that scenario but there’s also the possibility that the Fed puts the tapering process on hold. Some may argue such a move would pose some threat to its credibility but we should remember that the tapering announced in detail by December’s policy board was not meant to be a “steamroller” no matter if renewed uncertainties resurfaced along the way. Any threat to global economic growth may be countered by appropriate measures in this respect.

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