Light shines on emerging market debt
Lazard’s Denise Simon (pictured) and Arif Joshi see inflation peaking.
The first half of June was challenging for global markets as concerns continued to build over the sustainability of developed market growth and the potential for a more serious economic slow- down in China. By the middle of the month, the S&P 500 Index had fallen nearly 6% while emerging market debt spreads widened to 310 basis points (bps), a level not reached since September 2010.
The last week of June brought respite to markets, led by two critical pieces of data: First, Chinese Premier Wen Jiabao wrote an op-ed article in The Financial Times in which he essentially declared victory in the war against domestic inflation; Second, for the first time in two months, U.S. economic data finally exceeded expectations with better-than-expected results in both durable goods orders and manufacturing. As a result, emerging markets rallied sharply in the last week of June.
External sovereign debt returned 0.91%, as measured by the J.P. Morgan EMBI Global Diversified. Most of the return was attributable to spread compression. Meanwhile, local currency debt returned 0.46% in June, as measured by the J.P. Morgan GBI-EM Global Diversified. Returns in local debt were evenly distributed between rates and foreign exchange (FX) appreciation.
What a difference a week can make. After battling through seven weeks of consistently negative global data in May and June, global markets finally found respite with upside surprises in key markets. In China, we received the first formal indication from Premier Wen that 18 months of fiscal and monetary tightening is finally coming to a close. Surprisingly, China decided to send that indication via the op-ed page of The Financial Times as opposed to using a more mainstream outlet for policy announcements. Although an indication that the end of policy tightening is upon us, it is certainly not the “holy grail” for capital markets. As we have said before in our monthly letters, we believe that global asset prices can only sustain rallies if at least two out of three of the engines of global growth (China, the United States, and the European Union) are flashing positive signals simultaneously. In this case, the second indicator was positive durable goods data and manufacturing data in the United States in the last few days of the month. This data gave some credence (or perhaps just hope) to the mainstream (which includes Chairman Bernanke) that the US economy is on the verge of exiting a prolonged “soft spot” in growth.
Finally, we would be remiss if we did not comment on the ongoing turmoil in the periphery of Europe. While we currently do not hold (and do not currently intend to hold) any positions in the so-called “PIIGS” countries, we believe that a lack of action from European officials will only result in continued attacks by capital markets against the periphery. It is our view that Greece’s level of debt is unsustainable and only a longer-term debt write-down in some form could enable Greece and the periphery to recover from this unfortunate situation. It remains unclear whether or not the authorities will reduce Greece’s debt through market friendly or unfriendly measures, but we believe this is a prerequisite condition for capital markets, including emerging markets, to realize tighter spread and higher FX targets.
Where do we go from here? As we enter the second half of 2011, there is still considerable uncertainty throughout the developed world. In the United States, we are now embarking on a period in which the US Federal Reserve is no longer actively adding to its quantitative easing operations. Furthermore, elected officials will likely push negotiations on the austerity package closer to the August 2nd debt ceiling “drop dead” date before coming to any type of meaningful conclusion. Finally, earnings season will heat up again in the second half of July, giving much needed “bottom-up” data visibility as to the sustainability of the U.S. economic engine. We are generally positive on the outcomes of the aforementioned US trigger events; however, we are hesitant to put substantial capital to work prior to a meaningful resolution of each one.
In emerging markets, we believe the most important event has been (and will likely continue to be) the peaking of inflation in many markets. Inflation, historically the Achilles’ heel of emerging markets, has gone from the largest threat to asset prices, to an indicator that is rapidly moving to the rear view mirror. China is the largest country in emerging markets to see headline inflation begin to peak; however, we believe that many emerging market economies will likely post similar data throughout the second half of the year. The resulting easing of fiscal and monetary policy will place emerging markets in direct contrast to the developed world. We believe developed markets are still 6 to12 months away from even beginning this process.
Central banks in emerging markets have, by and large, been both effective and credible (with a few glaring exceptions, such as Turkey) in managing the growth/inflation trade-off, and we believe this will likely allow emerging market credit and equity assets to outperform over the next 12 months. It should be noted that although we are significantly more constructive on emerging market assets than just one month ago, global economic data remains choppy and inconsistent. As such, while we have added to long credit and local debt positions, we have remained in liquid instruments, and have resisted the urge to reach for yield in case the improving near-term trend falters.
Denise Simon and Arif Joshi manage Lazard Emerging Market Debt funds