Mon, 30/09/2013 - 13:08
Polina Kurdyavko (pictured), Partner and Senior Portfolio Manager at BlueBay Asset Management, on the changing dynamics of emerging markets and where opportunities can be found in EM corporates…
While emerging market dynamics are changing and are not as universally positive as they have been, we believe valuations have meaningfully corrected over the last few months and are starting to offer interesting entry points. However, credit selection and endogenous emerging market specific considerations are increasingly important differentiating factors.
The traditional emerging market growth model has changed. Easy growth driven by rising prices of commodity exports to supply China’s low-cost production and its domestic capacity build out is no longer applicable. Many countries need to adjust their policies to drive domestic growth and address imbalances. The changing environment means a world where we are seeing decoupling within emerging markets. As countries cope with changes in their economies, the quality of government policy is increasingly important and will have a significant impact on their economies and the corporates domiciled therein.
There is a growing distinction within emerging markets between those countries with current account and fiscal deficits and those with surpluses. Between those that are using the tools they have to undertake an appropriate policy response and those that are not.
Some countries were more exposed to commodity exports than others and saved during the good times. Others had currencies appreciate on the back of higher commodity prices and easy money, but let government spending grow, while manufacturing productivity and government efficiency did not improve. The result was fiscal and current account deficits when commodity demand fell, expensive and uncompetitive manufacturing sectors and less flexible economies.
Fundamentally, emerging market corporates have been affected by this transition, but the magnitude is not generally that material from a credit perspective. Most have strong enough balance sheets and sufficient liquidity to weather the transition.
Leverage has increased on average by only 0.2x over the last year, remaining relatively low. For investment grade credits from 1.1x debt to EBITDA to 1.3x and from 2.5x to 2.8x for high yield credits over the past two years. These are levels which are generally lower than US credits of similar ratings and are manageable, particularly when factoring in higher growth rates than developed markets, notwithstanding its decelerated pace, and favourable demographics. We believe the scope to increase leverage further is likely to be limited both by the market and by management given the changing environment.”
Risks do exist. However we feel those in our central case are already largely priced in (Fed tapering and slower growth). Meanwhile some risks are not priced in (the Fed hiking rates near term or an emerging market-specific crisis materialising), but these are unlikely scenarios.And, some perceived risks are greater than what is likely to be realized (FX depreciation impact on credit quality). How governments and corporates adjust their policies to the new global dynamics will likely be one of the main differentiating factors as we look forward. Fed tapering risk has diminished and is now less of an overhang than it had been. US growth continues to be slower than historical levels, and the fear priced into rates seems overdone given the 2’s -10’s curve had steepened to historical highs. In our view, the Fed will likely remain accommodative in the near term, which is supportive for fixed income generally and particularly for spread products such as emerging market corporates. Slower growth in emerging markets is already being felt and in large part is the cause of the recent underperformance of emerging market sovereign and corporate spreads. The adjustment process, while nascent, has already begun as currencies have depreciated and policy action adjusted. For most countries and companies, balance sheets are relatively strong in our view and flexible exchange rates should allow for a self-adjusting process to begin.
On the whole corporates have good balance sheets and liquidity. Management should adjust the pace of CapEx to match new growth levels, which would increase cash flow and preserve liquidity. There are some companies with weaker business plans and overly high leverage or short-term debt, who were only able to issue due to easy credit conditions. These companies are likely to be at risk. Others have inherently good businesses, have been prudent in their deployment of capital and balance sheet management. These companies may experience a dip in earnings, but should remain sound from a credit perspective.
As we have highlighted, after a meaningful correction, we believe emerging market corporates as an asset class look attractive to the well-informed investor.
Emerging markets have recently come under pressure as a combination of tighter global monetary conditions and, in some cases, deteriorating fundamentals have hit confidence. However, as we have discussed, there is a growing distinction within emerging markets between those countries with current account deficits versus surpluses and those that are undertaking an appropriate policy response and structural reforms and those that are failing in their policy response. Mexico is a good example of a country where economic reforms are underway and the medium-term growth profile is improving. Meanwhile Indonesia and India highlight where the reform process needs to be prioritised. It is therefore difficult to make generalisations, but we note that overall emerging markets are in much better shape today than they were in prior times of stress. Sovereigns have much stronger balance sheets and a lower share of debt in foreign currency.
Corporate debt maturities have been termed out and near-term payment pressures are modest. Within emerging market corporates there has been a deterioration in fundamentals across the more cyclical sectors. However, this has come from a relatively strong starting point. Spreads have also corrected and are now close to the recent wides when compared to similarly rated corporates in the US. Our bottom-up default analysis projects a 1% default rate for the asset class (or 3.3% purely for the high yield segment), which is below the historical average and supports the case for spread compression over the course of the next 12 months.
In the very short term we expect a round of supply in the primary market, which is likely to contain any near-term spread compression.
Given our defensive stance, we expect to be able to capitalise on some of this new supply as it comes to market at what should be attractive levels (given the stagnation in the primary market over the last three months).
“Nevertheless, we maintain our constructive stance towards the asset class. Most countries and companies have strong balance sheets and do have the tools to navigate the current environment. In terms of asset class returns, in an environment of gradually rising US rates, and based on our default projections which suggest some compression in emerging market corporate spreads, we would expect a positive return within the asset class over the next twelve months.
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