Finisterre Capital’s Xavier Corin-Mick and Paul Crean expect more fixed income decisions on fundamentals
Xavier Corin-Mick, portfolio manager of the Finisterre Sovereign Debt Fund and Paul Crean, CIO, see particular shifts taking place in the emerging market fixed income space through 2014.
2013 is over and will be remembered as just the third year in twenty when EM fixed income generated negative returns, failing to be bailed out by another rally in spreads, coupons, or risk-free yields. Trees do not grow to the sky and too many had previously mistaken past returns for a prediction of the future. As 2013 has ended and we now try to predict the “future”, one has to have a view on current valuations and yields, the direction of risk free rates and, as many were reminded last year, the relative perception of emerging market vulnerabilities and strengths.
As an EM fixed income investor, we have long been concerned about these vulnerabilities; the misallocation of capital in EM, the mismatch between liquidity of secondary markets and the size of the dedicated long-only universe, and the shift in momentum away from EM towards the developed world as “recovery sprouts” keep surfacing and boost DM equities and periphery bonds. EM asset valuations have improved vs. other assets and sentiment has shifted away from the hype witnessed in previous years so we are more constructive on selected stories. 2014 should see a further fragmentation of “EM” and a redefinition of the universe as markets look for new acronyms to differentiate between countries.
The direction of risk free rates is the “elephant in the room” and calls for a proper view on valuations vs. fundamentals as well. We hold to the view that the start of tapering will allow investors to start buying duration selectively in high grade USD and local-currency debt of countries with some “convergence” momentum – Mexico and Poland in particular. The investor base in these countries should keep shifting away from “inflows vulnerable” dedicated index money towards more strategic investors looking for diversification away from DM fixed income. As far as DM fixed income is concerned, 3% yield on 10y US rates seems like an adequate level for the foreseeable future, but calling shots on where US rates normalization ends is clearly the most difficult part of risk allocation.
Looking at relative level of yield and spreads, we noticed a very large divergence of asset performance that started in 2013 – high yield outperforming high quality, USD debt losing 5% less than local debt, and currencies of CAD countries getting aggressively sold while those of surplus countries mostly escaping the headlines. The call on country and asset selection has proven challenging this year – rewarding for the most part, but at times also incredibly frustrating. Frustration today usually means opportunities and returns in the future, particularly regarding what we think is the next leg of the move: markets discriminating between the CAD countries, focus shifting away from short-term flows of cash (CAD) into longer-term issues of stock of debt, refinancing, and political risk.
The end of 2013 saw the most striking dislocations in less liquid mid-duration toxic assets versus liquid and longer-dated IG assets. We have seen a pattern in markets where the winner of one year takes it all in the first few days of the following year only to get hit shortly afterwards as positioning gets extreme and valuations move further out of place: this year should not be different.