Steve Drew, Head of Emerging Market Credit, talks about the unprecedented flows into the asset class in 2016 and why he believes, apart from the obvious political developments, other themes in 2017 are likely to broadly reflect those of this year.
What lessons have you learned from 2016?
Emerging market fundamentals have been fairly benign since the start of the year when political risk in Brazil was diffused by the impeachment process. 2016 revealed that the direction of emerging market corporate bond markets can be driven as much by external events as internal. The strong returns from February to September were unexpected and driven by unprecedented levels of central bank intervention, while the search for yield in turn prompted unprecedented flows into the asset class.
What are the key themes likely to shape the markets in which you invest in 2017?
It is too early to say if we are now entering a ‘taper tantrum’ type scenario as in 2013. Many parallels between now and then have been drawn, but so far the sell-off feels orderly. Yes, emerging market bonds have experienced large outflows since Trump became the US President-elect, but these pale into insignificance when compared to the size of the inflows year-to-date. So far this year, inflows into emerging market hard currency funds now stand at $39bn.
Away from the obvious political developments, other themes are likely to remain little changed compared to 2016. At a micro level, many companies have spent the last two years managing their liabilities, which means that most refinancing needs have already been met. This is likely to keep a lid on net supply in 2017. Regional themes are also expected to remain a constant. For example, in Asia 95% of new issues will continue to be bought by local accounts, with Chinese investment grade bonds still dominating new issuance.
We do not expect to see a pick up in defaults. Emerging market defaults are already running at a lower rate than in developed markets. The pick up in defaults earlier in 2016 was mostly driven by Latin American oil and gas credits, and as with US high yield energy companies, those credits that needed to default have mostly done so now.
We expect to see continued issuance from sovereigns in 2017, in particular out of the Middle East. The budget deficits of these oil-dependent economies are likely to make them frequent issuers in the debt capital markets in a way that they have not been in the past, since the oil price appears to be entrenched in the $40-50 per barrel range.
What are your highest conviction positions moving towards the new year?
Our highest conviction trades moving into the new year are those positions that are as much as possible uncorrelated to the broader market direction. By this we mean:
- Secular growth stories: such as IHS, a Nigerian towers business, which is well-positioned for growth in mobile penetration rates and has little to no link to commodity prices or interest rates.
- Least volatile issues from higher quality companies: such as short-dated Petrobras bonds.
- Defensive plays: such as Chinese investment grade names in companies, which either have explicit government support or implicitly are likely to be deemed ‘too big to fail’.
- Sovereign issuers, which offer compelling value.
The portfolios will also continue to focus on the more liquid issuers.
What should investors expect from your asset class and your portfolio going forward?
Emerging market bonds will continue to be dominated by external rather than emerging market specific events. We do not see any one country, sector or company likely to derail emerging markets, unlike Brazil this time last year. There are, however, plenty of external events on the horizon to shape our thoughts going forward, starting with the US Federal Reserve (Fed)’s meeting in December. We expect the Fed to hike interest rates by 25 basis points but to maintain a dovish tone and allow for 1-2 rate hikes next year. A dovish Fed statement should be sufficient to set the tone for a ‘carry’ year for emerging market corporate bonds, although with a decent tail risk on either side.