Written By: Matthew Murphy
Matthew Murphy of Eaton Vance Management says that in-depth proprietary research into the Emerging Markets sector shows that there are many investment opportunities here, and decisions should not be based simply on whether the countries are in a benchmark
In the past 10 months, Covid-19 has changed the investment landscape for emerging markets (EM) debt, injecting a broad new dimension of economic uncertainty. The impact varies widely across EM countries – in many ways, the imperative to balance “lives vs. livelihoods” parallels the challenges faced by developed economies. But many EM countries with less diversified, less resilient economies also have unique problems that are exacerbated by Covid-19, especially among the poorest and most vulnerable populations.
From an investment perspective, today’s environment underscores a key tenet of the Eaton Vance EM debt team: specifically, that benchmark-based investment approaches may be suboptimal. And yet, most EM strategies are based on indices. Why do we consider index-based strategies lacking? For one, there’s benchmark valuations. While they may be unattractive from an asset price perspective, at any given time they are (by definition) required holdings for benchmark-based strategies.
Index concentration is another factor. In the J.P. Morgan Government Bond Index – Emerging Markets (GBI-EM), the top 10 countries account for 80% of its weight, as of 31 December 2020. Concentration of a relative handful of larger EM issuers has been a major source of the index’s volatility historically and the market impact has grown in step with the rise of index-based EM ETFs.
In contrast, there are 70 investable markets outside of the GBI-EM, with approximately US$1.1 trillion worth of local-currency market capitalisation. Non-benchmark securities are not as well covered by sell-side analysts, so are more frequently mispriced. Ruling out such countries greatly reduces the opportunity set and alpha potential.
In brief, investing in EM countries simply because they are in a benchmark has always been a weak premise, and it is even more so after Covid-19.
The Mexican dilemma
Consider Mexico, which represents about 10% of the GBI-EM. The country’s healthcare system is a shambles, with one of the lowest testing rates for Covid-19. Because most employment is informal, many workers cannot work remotely or even have pay deposited automatically.
Yet as part of the global supply chain, the economy faces tremendous pressure to re-open. New cases of Covid-19 continued to remain elevated in Mexico, well after 10 months of the pandemic. Whether it can sustain economic re-opening with the major problems in healthcare and testing is a major question.
The federal budget relies heavily on oil production and exports. Thus, the plunge in oil prices last year stung fiscally and economically. Growth may have tumbled as much as 10% in 2020 – even prior to the pandemic, the Mexican economy was held back by policy uncertainty, reduced investment and weak consumption.
This description doesn’t take a view on the country’s debt, because it doesn’t address relative value. It simply emphasises that any rationale for investing in Mexico in today’s environment has to be more than the fact that it is part of a benchmark.
If Covid-19 has made struggling economies like Mexico worse, its impact is also being felt by EM success stories as well. Consider Central and Eastern Europe – Poland, Hungary, Romania and Czech Republic. The region had been thriving pre-Covid, thanks to rising demand for car exports, electronics and supply-chain parts, all of which are key regional exports.
With economic lockdown across Europe, the short-term disruption in this story has been plain. For example, Polish logistics companies provide components for Germany’s carmakers, but demand has suffered.
For the longer term, other questions loom, such as how far will the de-globalisation trend go? From one perspective, de-globalisation could hurt Eastern European countries if their customers push to keep suppliers local. By the same token, these economies could benefit if companies with complex international supply chains bring production back from Asia to Europe.
There is no simple approach to predicting how EM countries will fare with the added hurdles posed by Covid-19, nor a formulaic method for determining when and if their debt is priced to fully reflect them.
Currencies and other risk factors
We have long believed that the best way to pursue alpha in EMD is through a bottom-up focus on country-level macroeconomic and political research, and stand-alone analysis of specific risk factors. EM bonds are aggregates of risk factors – interest rates, currency, and sovereign and corporate credit spread (over its respective sovereign spread). This approach lets us disaggregate and evaluate these idiosyncratic risk factors at the country level.
Major dislocations, such as we have discussed above, offer opportunities that are possible through a commitment to capitalising on all risk factors, like currencies.
A good current example involves most of the countries of the Gulf Cooperation Council (GCC), save for Kuwait – i.e. Saudi Arabia, Oman, Bahrain, Qatar and the United Arab Emirates (UAE). Historically, currency pegs to the US dollar have been a way for the Gulf countries to use their huge dollar-denominated revenue streams from oil to maintain the purchasing power of local currencies and political stability.
But the collapse in oil prices and a surging US dollar in the wake of the pandemic outbreak brought renewed attention to monetary and foreign exchange (FX) policy in the GCC, and questions about whether continuing the dollar pegs is feasible or desirable.
By June 2020, the deficiencies of the pegs were becoming apparent, as they were artificially inflating the value of GCC currencies. For example, Russia has much better fiscal numbers and FX reserves than Oman, yet the Omani rial appreciated 15% versus the Russian ruble in the first half of the year. Similarly, the UAE’s currency appreciated 15% versus Turkey’s. The two countries compete in tourism and airlines, and the relative strength of the UAE’s currency is a disadvantage.
The potential shift in dollar-peg GCC countries to free-floating bears close watching, particularly for flexible investment approaches that can capitalise on potential currency mispricings as they occur.
Fiscal woes and defaulting debt
Just as in developed markets, extraordinary fiscal and monetary interventions are now underway in EM countries. Such actions can pose serious hazards for passive, index-based portfolios, and indeed any strategies lacking a source of in-depth, proprietary expertise about local economies and the policies driving them.
Consider South Africa, which represents about 7% of the GBI-EM. While the country historically has been considered one of the higher-quality EM countries, markets are now doubting that assessment (as we have for years), and its currency was punished in April last year.
South Africa illustrates the tensions that are likely to grow between the need to stimulate EM economies and obligations to external bondholders – benchmark countries are not immune to this pressure. In 2020, Ecuador, Lebanon, Argentina and Zambia defaulted. Angola is in negotiations with creditors, while a number of others countries remain “on watch.”
The EM sector “comes of age”
The ability for EM central banks to lower rates is an important milestone for the sector. During previous debt crises, they typically were compelled to raise rates to defend their currencies. This milestone should be seen as a broader “coming of age” phenomenon for EM debt: Investors are no longer treating the sector monolithically. There is an understanding that EM countries must cope with this crisis but did not cause it, as in prior years.
Across EM countries we are seeing investors differentiate based not just on their dependence on oil, but on varied policy responses to the virus and the potential impacts on healthcare systems, social dynamics, economies and finances.
Why selectivity matters more than ever
A number of factors are in play with disparate impacts on EM issuers, and indicate that the need for selectivity by country has grown, such as:
- Coping with the dual shocks of oil prices and recession: As the Gulf examples show, this is a double whammy for many EM countries, but some oil importing nations will benefit.
- Outsized fiscal spending: Large stimulus packages that don’t succeed in jumpstarting economic growth jeopardise the ability to service dollar-denominated debt.
- Debt relief: In response to an April request of the IMF and World Bank, the G20 countries agreed to suspend debt service payments through the end of the year – relief that could total $20 billion from public and private creditors.
- Low EM rates: Local currency rates are at or near historic lows making value harder to find.
- FX values: Foreign currencies are generally supported by strong economic growth and credible monetary policy. But in many cases, central banks are using weaker currencies as a crutch for exporters at the expense of broader growth, raising concerns of “beggar thy neighbour” policies.
- Balancing health and growth: As with developed nations, each EM country must find an optimal path to economic recovery that doesn’t jeopardise its healthcare system.
These examples underscore that due diligence and vigilance are the order of the day in the EM sector, and that there is no substitute for active, in-depth proprietary research. But with the proper tools to navigate the new landscape we believe there are numerous opportunities in the sector.
A major irony of today’s market is that fund flows in the sector are still driven by index-based strategies that ignore fundamentals, even as many investors have come to recognise just how crucial individual EM country fundamentals will be in surmounting Covid-19 challenges.
This recognition just underscores the need for proprietary research in EM debt and the sophistication to capitalise on multiple risk factors. In a world that the pandemic has changed in so many ways, it remains the best way we know to generate alpha for our clients.
Sources of data: Eaton Vance, 19 January 2021. Data is as at 31/12/2020, unless otherwise specified.
This material is presented for informational and illustrative purposes only. It should not be construed as investment advice, or to adopt any particular investment strategy. Investment views, opinions, and/or analysis expressed constitute judgments as of the date of this material and are subject to change at any time without notice.
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