Valuations, Fundamentals and Positioning: How to Spot Red Flags in Emerging-Market Debt

Recorded on 10 June 2022.

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Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Lisa Chua:

Hello, everyone. My name is Lisa Chua. I'm a portfolio manager on the Emerging Markets Debt team. I'd like to spend some time today talking to you about our investment process, and more importantly, giving you a real life example of how we apply that process, focusing on Russia. We believe that having a disciplined investment process is key to generating strong risk-adjusted returns across our strategies and over market cycles. If I were to put our process into three words, it would be fundamentals, valuations, and positioning. When looking at fundamentals, we first start with a country ranking model to compare all the countries in our universe on an apples to apples basis. This tool uses as inputs, a number of macroeconomic variables that have historically had a high correlation with the country's ability to pay back its external debt.

The inputs are shown on the spider chart on the left-hand side of the slide. And you can see that this includes balance sheet metrics such as debt to GDP, as well as flow measures, such as budget and current account balances as a share of GDP. This is also where we first start to look at ESG scores for the countries as well. With ESG integrated into the investment process so we can understand potential risks to the overall credit profile. Each of the countries in our universe perceive the weighted average z-score based on how they score across each of these metrics relative to the overall emerging market universe. A z-score of zero would be in line with the mean score of the universe. With higher scores, implying stronger fundamentals based purely on the output from the model. It's important to note that this is simply a starting point for comparisons and discussions and the process of dynamic.

You need to be forward looking in response to news flow and changing circumstances that might change the trajectory of the score. So spite the chart on the left-hand side is one of the outputs from the country ranking model that allows us to then drill down into how any given country scores across each of the metrics and to make comparisons relative to peers. In this chart here we are comparing Russia, which was investment grade prior to the invasion of Ukraine to other investment grade issuers. Focusing on the left-hand spider chart, you can see the scores for Russia across the different metrics in yellow. Russia scores favorably on most macroeconomic variables, even relative to investment grade peers, driven by low debt levels and relatively solid fiscal and external accounts. Growth shows that the weak spot currently, as you can see from the negative score on the spider chart, due to the impact from the war and from sanctions, but prior to the invasion, this would've looked better as well.

The other weak point is on the ESG score. And when we drilled deeper into the drivers behind that score, we noticed that this was driven by weaker governance scores. On the right-hand spider chart, we are further dissecting the drivers behind the governance indicators, and you can see that with the exception of government effectiveness, it scores weaker relative to the overall universe on all five other governance indicators as shown by the negative Z scores. Moreover, when we looked at overall trends prior to the invasion, these scores, rule of law, control of corruption, and political stability, had consistently been low. And in some cases deteriorating, such as on voice and accountability and regulatory quality. These issues were warning signs to us early on of potential risk on the ESG side and these risks took center stage as Russia started amassing troops at the border of Ukraine in the months before the invasion.

Moreover, many of these risks were not priced into the valuations. Five year CDs spreads in December 2021 and going into the start of the year were barely 120 basis points. With the market ignoring weak governance indicators and increasing tension at the border. In addition to looking at fundamentals and valuations when investing in emerging markets, we also think it's important to focus on positioning. One way we do that is by regressing the returns of our peers to different segments of the asset class to better understand not only how crowded positioning may be, but to also identify where market participants may be taking their risks. And finally, we also use positioning tools to get a sense of how market participants are positioned across different countries relative to their respective benchmarks.

This slide here is showing you the output of a regression analysis of emerging market, hard currency fund managers in Russia and Ukraine in the weeks leading up to the invasion. A positive coefficient indicates that market participants will overweight relative to their respective benchmark while zero would be neutral. If you focus on the first column on Russia and the first row, you can see that at the start of the year in January 2022, many market participants were running overweight to Russia despite rich valuations. Over the coming weeks as geopolitical tensions, intensified market participants started reducing their positions in Russia.

As you can see by the coefficient decreasing as the weeks progress. However, although the size of the positions had decreased, market participants were still broadly overweight by Russia, as you can see from the positive coefficient, even as of February 16th, one week before the invasion. Moreover, if market participants were truly concerned about downside risk related to an invasion, they should have also been decreasing positions in Ukraine, but that wasn't the case. Looking at the Ukraine column, you can see that in January 2022 market participants were overall neutral to Ukraine. They were running coefficients close to zero or marginally negative, but by the middle of February, market participants had increased exposures to Ukraine and were running overweight's a week before the invasion. This highlights a level of complacency that the market had gotten accustomed to. And the grab for yield mentality as bond prices in Ukraine, moved from the nineties, from par to the '90s and into the '80s.

Many peers were taking a by the dip approach rather than weighing the downside risk, which were still much larger than the potential upside. When you consider that market participants were still running overweights in Russia and were increasing positions in Ukraine, it becomes very clear that the market was largely ignoring the risk of the escalation of a conflict.

On the governance side, voice and accountability is likely to continue to deteriorate as the government forbids public opposition to the war and seeks to consolidate control, as well as by all the rights abuse committed by troops during the evasion. Over the medium term, social pressures are also likely to increase as a result of the war and sanctions raising the risk of civil unrest. On a broader note, rare of the view that investing in emerging markets will continue to require a disciplined integrated process that incorporates both historical and forward looking ESG elements, alongside fundamentals, valuations, and market positioning. Thank you for your time today in listening to this. And if there are any further questions, please don't hesitate to reach out to your relationship managers. Thank you.