In defence of co-investing with the state
It’s hard to avoid state-run companies if you are investing in emerging markets — after all they make up a third of the main EM equity index, run by MSCI. But should one be avoiding shares in these firms?
Absolutely yes, says John-Paul Smith at Deutsche Bank. Smith sees state influence as the biggest factor dragging down emerging equity performance in the longer term. They will underperform, he says, not just because governments run companies such as Gazprom or the State Bank of India in their own interests (rather than to benefit shareholders) but also because of their habit of interfering in the broader economy. Shares in state-owned companies performed well during the crisis, Smith acknowledges, but attributes emerging markets’ underperformance since mid-2010 to fears over the state’s increasing influence in developing economies. (t
Jonathan Garner at Morgan Stanley has a diametrically opposing view, favouring what he calls “co-investing with the state”. Garner estimates a basket of 122 MSCI-listed companies that were over 30 percent state-owned outperformed the emerging markets index by 260 percent since 2001 and by 33 percent after the 2008 financial crisis on a weighted average basis. The outperformance persisted even when adjusted for sectors, he says (state-run companies tend to be predominantly in the commodity sector).
Past performance and state support aside, Garner sees two inducements to buy shares in state-run companies. Firstly, they tend to trade relatively cheaply to their private sector peers (almost certainly because of the risks that state involvement is perceived to bring). Morgan Stanley calculates these companies are a fifth cheaper than the broader index, both on a forward price/earnings basis and on a price/book basis.
Secondly, many of these companies now pay decent dividends. Garner’s sample group of companies exhibits a dividend yield of 3.2 percent versus 2.7 percent for the MSCI index. That’s up from 1 percent in 2007 and should rise to 4 percent in 12, Morgan Stanley predicts.
It also expects a 15 percent upside to the share price for state-run companies.
Emerging market local bond rally has more legs
Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.
There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.
Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes:
From an EM perspective there is little reason to fight the rising tide of monetary policy support in the near term. Comparisons to the 2009 global carry trade are unavoidable given the scope of G-4 central bank balance sheet expansion.
So far, around 70 percent of the gains posted by the GBI-EM index have been down to currency appreciation (see here). That could change going forward as some central banks may act to slow FX appreciation. That’s already been happening in Brazil. Gains from the duration trade — derived from interest rate cuts — are also more or less done, analysts reckon, because emerging central banks are more likely from here to keep interest rates on hold than to cut. J.P. Morgan adds:
While we look for approximately 7 percent in additional returns in the GBI-EM for the remainder of the year, the majority of this is due to carry (5 percent) while spiot FX returns should be muted at 1.9 percent and duration returns flat.
What to do with Belize’s superbond
This year’s renewed euphoria over emerging markets has bypassed some places. One such corner is Belize, a country sandwiched between Mexico and Guatemala, which many fear is gearing up for a debt default. There is a chance this will happen as early as next week
Belize is a small country with just 330,000 people but back in 2007, it issued a $550 million bond on international markets. Known locally as a superbond for its large size (relative to the country’s economy), the issue earned Belize a spot on JP Morgan’s EMBI Global index of emerging market bonds.
As this index is used by 80 percent of fund managers who invest in emerging debt, many of them will have allocated some cash to hold the Belize bond in their portfolios. These folk will be waiting anxiously to see if Belize pays a $23 million coupon due on Feb. 20.
Never very liquid, the bond has taken a sharp lurch downwards since Feb.7 when Prime Minister Dean Barrow said in a pre-election speech that he would seek “instructions” from the electorate to “do something about the bond”. That unsurprisingly triggered panic selling and the bond now trades around 40 cents on the dollar, down some 20 cents since the start of February. The yield has risen sharply to 23 percent from 16 percent and and the Belize spread over U.S. Treasuries — the premium that investors demand to hold the bond — has blown out to almost 2000 basis points, higher than any other country in the EMBI Global index. That’s a rise of 400 bps since the day of Barrow’s speech.
Exotix, a frontier market-focused brokerage says:
What happens next? We think the government will pay the forthcoming 20 February coupon but clearly there is a risk that it won’t. But even if it does, that does not remove the uncertainty now hanging over the bond… The government has the money and it might be counterproductive politically to default just before a general election. However we do acknowledge that the bond’s domestic unpopularity and the low price make non-payment an easier option.
Regionally, there are some parallels with Ecuador which in 2008 defaulted on debt the government said had been contracted unlawfully by a previous administration. Investors pointed out at the time that Ecuador’s president Rafael Correa had the cash to pay but did not want to. If Belize misses the Monday coupon, it will not be for want of cash — the central bank has $240 million in its coffers.
Emerging Markets: the love story
It is Valentine’s day and emerging markets are certainly feeling the love. Bank of America/Merrill Lynch‘s monthly investor survey shows a ‘stunning’ rise in allocations to emerging markets in February. Forty-four percent of asset allocators are now overweight emerging market equities this month, up from 20 percent in January — the second biggest monthly jump in the past 12 years. Emerging markets are once again investors’ favourite asset class.
Looking ahead, 36 percent of respondents said they would like to overweight emerging markets more than any other region, with investors saying they would underweight all other regions, including the United States. Meanwhile investor faith in China has rebounded with only 2 percent of investors believing the Chinese economy will weaken over the next year, down from 23 percent in January. China also regained its crown of most favoured emerging market in February.
Last year, the main EM index plummeted more than 20 percent as emerging assets fell from favour. So what is the reason for this renewed passion in 2012?
Firstly December’s LTRO — a multi-billion euro liquidity arrow from the cupids at the ECB has revived investor appetite for riskier emerging assets, boosting the index to around six-month highs since the start of the January. A second significant factor behind the resurgence in risk sentiment is that the market is daring once again to hope for an improvement in global growth, says Gary Baker, BofAML Global Research head of European equities strategy.
The big beneficiaries of all this have been emerging markets. It’s not just about liquidity. Clearly the actions of the ECB have been vitally important… but what you’ve also seen is an improvement in global growth optimism. If optimism over growth is improving then there may well be a more fundamental underpinning to the movement.
So is investors’ new-found love for emerging assets a passing flight of fancy or a true sign of commitment?
The significant monthly improvement in market sentiment towards emerging markets and the 44 percent level of investors overweight emerging markets are both events which have historically coincided with short-term underperformance by emerging equities, Baker says.
Interest rates in emerging markets – - harder to cut
Emerging market central banks and economic data are sending a message — interest rates will stay on hold for now. There are exceptions of course.
Indonesia cut rates on Thursday but the move was unexpected and possibly the last for some time. Brazil has also signalled that rate cuts will continue. But South Korea and Poland held rates steady this week and made hawkish noises. Peru and Chile will probably do the same.
The culprit that’s spoiling the party is of course inflation. Expectations that slowing growth will wipe out remaining price pressures have largely failed to materialise, leaving policymakers in a bind. Tensions over Iran could drive oil prices higher. Growth seems to be looking up in the United States.
On top of that, all the major central banks in the developed world are intent on flooding the world economy with cash and some of it will inevitably make its way to emerging nations. So while economies could do with a good dose of policy easing, most central banks cannot afford to let their guard down on inflation.
Take China where January inflation came in well above expectations on Thurday, with food prices up 10.5 percent on the year. Expect no cuts to the policy rate this year, warn analysts at RBC. Over in Seoul, Bank of Korea governor Kim Choong-soo said policymakers needed to be “on alert” for inflation risks and described inflation expectations as “considerably high.” The verdict from Barclays:
Taken together these comments reflect a tilt in concern towards inflation.
Most central banks in emerging Europe never had much room to cut rates anyway, exposed as they are to the euro zone malaise. But as my colleague Emily Kaiser wrote a week back, policy easing bets in Asia are also being trimmed.
Currency rally drives sizzling returns on emerging local debt
Emerging market bonds denominated in local currencies enjoyed a record January last month with JP Morgan’s GBI-EM Global index returning around 8 percent in dollar terms. Year-to-date, returns are over 9.5 percent.
This is mainly down to spectacular gains on emerging currencies such as the Mexican peso and Turkish lira which have surged 7-10 percent against the dollar and euro this year. Analysts say the currency component of this year’s returns has been around 7 percent, meaning any portfolio hedged for currency risk would have garnered returns of just 2.5 percent.
The gains come as good news to investors licking their wounds after the index ended 2011 in negative territory. A mid-year rout on emerging markets pushed up local bond yields, often by hundreds of basis points and sent many currencies to multi-year lows.
Now, promises of more cheap cash from Western central banks has changed the mood, driving currency rallies. Adding to the optimism is the hope of more interest rate cuts in emerging markets, where inflation has peaked and growth is slowing.
Emerging markets facing current account pain
Emerging markets may yet pay dearly for the sins of their richer cousins. While recent financial crises have been rooted in the United States and euro zone, analysts at Credit Agricole are questioning whether a full-fledged emerging markets crisis could be on the horizon, the first since the series of crashes from Argentina to Turkey over a decade ago. The concern stems from the worsening balance of payments picture across the developing world and the need to plug big funding shortfalls.
The above chart from Credit Agricole shows that as recently as 2006, the 34 big emerging economies ran a cumulative current account surplus of 5.2 percent of GDP. By end-2011 that had dwindled to 1.7 percent of GDP. More worrying yet is the position of “deficit” economies. The current account gap here has widened to 4 percent of GDP, more than double 2006 levels and the biggest since the 1980s. The difficulties are unlikely to disappear this year, Credit Agricole says, predicting India, Turkey, Morocco, Tunisia, Vietnam, Poland and Romania to run current account deficits of over 4 percent this year.
Some fiscally profligate countries such as India may have mainly themselves to blame for their plight. But in general, emerging nations after the Lehman crisis were forced to embark on massive spending to buck up domestic consumption and offset the collapse of Western export markets. For this reason, many were unable to raise interest rates or did so too late. As the woes of the Turkish lira and Indian rupee showed last year, the yawning funding gap leaves many countries horribly exposed to the vagaries of global risk appetite.
There are some supportive factors however. The Fed’s signal this week that U.S. interest rates are unlikely to rise before 2014 shows that central banks in Europe and the United States will continue to gush money for now. So there should be enough cash available to plug the gaps in emerging nations’ balance sheets. Second, as growth eases, so will the deficits. For these reasons, Credit Agricole says the market will be forgiving of large current account deficits this year. But it warned:
What will happen once (developed market) rates are raised is another story, and emerging markets would better have fixed their main imbalances when the global monetary normalisation begins.
Emerging consumers’ pain to spell gains for stocks in staples
Food and electricity bills are high. The cost of filling up at the petrol station isn’t coming down much either. The U.S. economy is in trouble and suddenly the job isn’t as secure as it seemed. Maybe that designer handbag and new car aren’t such good ideas after all.
That’s the kind of decision millions of middle class consumers in developing countries are facing these days. That’s bad news for purveyors of everything from jeans to iphones who have enjoyed double-digit profits thanks to booming sales in emerging markets.
Brazil is the best example of how emerging market consumers are tightening their belts. Thanks to their spending splurge earlier this decade, Brazilian consumers on average see a quarter of their income disappear these days on debt repayments. People’s credit card bills can carry interest rates of up to 45 percent. The central bank is so worried about the growth outlook it stunned markets with a cut in interest rates this week even though inflation is running well above target
All that bodes ill for shares in companies selling so-called consumer discretionaries in developing countries – non-essential items such as autos and high-end cosmetics.
But someone’s loss is someone’s gain. Shares in companies selling consumer staples –food, beverages, prescription meds and tobacco — are starting to pick up. In short, everything that outperforms during economic downturns. MSCI’s index of emerging market staples is flat on the year, doing only slighly better than consumer discretionaries. But guess what? In August, when everything was selling off staples did ok. They fell 2.4 percent, much better than MSCI’s discretionaries index which lost 8 percent.
Bank of America/Merrill Lynch’s monthly survey shows fund managers went overweight consumer staples in August for the first time this year. Back in January when investors were optimistic about the U.S. economic outlook, almost 60 percent of fund managers were underweight staples. They still like discretionaries but cut that position pretty sharply last month.
What of Brazil? Carlos de Leon, a fund manager at RCM still sees opportunities there, especially as minimum wages will rise by an above-inflation 12 percent next year. But unsurprisingly, his picks are consumer staples and defensives including toll road operators, fuel distributors and utilities.
Venezuela — high risk, higher yield
Which bond would you rather buy — one issued by a country with an unpredictable leader but huge oil reserves, or one with a dictatorial president as well as empty coffers? The answer should be a no brainer. Not so. The countries are Venezuela and Belarus, and a basic comparison of their debt profiles shows how strangely risk can be priced in emerging markets.
Venezuela’s 2022 dollar bond yields 15.5 percent while the 2022 issue from state oil firm PDVSA trades at 17 percent yield. Venezuelan debt pays a 1200 basis point premium to U.S. Treasuries, according to the EMBI Global bond index.
Now check out Belarus. Dire public finances, a huge recent currency devaluation, and seeking an $8 billion bailout from the IMF, yet able to pay 11 percent on its 2018 issue. Its yield premium to Treasuries is 900 bps or three percentage points less than Venezuela.
Is such a huge risk premium on Venezuela justified? RBC analyst Paul Biszko says Venezuelan yields should logically be 300-400 bps lower than current levels, given the strong recent track record in servicing debt — it did not miss a payment even when oil prices fell to $10 a barrel a decade back. Oil is well over $100 a barrel now, yet investors seem unwilling to trust in President Hugo Chavez’ willingness to keep up payments.
“People see him as one day saying he won’t pay so there is limited sponsorship externally for the bonds,” Biszko says. “Meanwhile those who do hold it get rewarded with high premiums…it doesn’t make sense that the premium is double that of Argentina.”
Sure, Venezuela’s economy isn’t in great shape. Inflation is running at 30 percent a year. There is an election coming up. Also, PDVSA has a $2.5 billion bond maturing mid-July. But Chavez is a shoo-in for the election while PDVSA has enough money to pay the bond. And no one can doubt Venezuela’s ability to pay — Barclays estimates its trade surplus this year may hit $90 billion.
Exotix economist Stuart Culverhouse suggests buying the 2019 and 2022 Venezuelan bonds, citing the high yield. ”Concerns over willingness to pay…to some extent overstate Venezuela’s default risk,” he says.
The long term problems with Venezuelan debt are aren’t insignificant. The country has used massive amounts of future oil supplies as collateral for loans from China, so long term ability to pay is diminished. Additionally, the underinvestment in the country’s oil infrastructure is starting to reduce output. Granted, proven reserves are immense but twelve years of Chavez rule have turned the country into a basket case. The country imports everything at this point and the government has turned to complete control over the currency market to cover up what I believe is a coming crisis in forex reserves.
Yes, Chavez will play the safe game with the debt until his reelection next year (an almost certitude). After the election, he’ll have much less incentive to pay on good terms. Given the decision to pay debt payments or pay for absolutely necessary improvements in infrastructure I wouldn’t bet on payments. He may not immediately default the bonds, but a threat of nonpayment is not so unimaginable. Here is the real danger in Venezuelan debt, with hightened levels of risk must come higher yields. As yields increase, prices must decrease. Unless you are planning on holding the debt to maturity you will not realize your expected yield if you have to sell the bonds for a discounted price.
I would not invest in Venezuelan debt but I probably would not invest in Belorussian debt either. At minimum, the investment should be hedged with some kind of default swap or option relevant to your holding period.
Joseph Hogue is a Research Economist for the State of Iowa. He is a candidate for the level III CFA exam and sits on the board of the CFA Society of Iowa.
Investors love those emerging markets
No question that investors are in the throes of passion over emerging markets. The latest Reuters asset allocation polls show investors pouring money into Asian and Latin American stocks in October to the detriment of U.S. and euro zone equities. Exposure to equities in emerging Europe, Asia ex-Japan, Latin America and Africa/Middle East rose to 15.6 percent of a typical stock portfolio from 14.3 percent a month earlier.
