A Vicious Circle: Q3 Outlook for EMD

Despite cheap valuations, we believe emerging market debt investors are still not being adequately compensated for increased levels of risk in the asset class amid stalling EM current account balances.


Recorded on 16 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.

Hi. I'm Guillermo Osses with emerging markets debt team at Man GLG. The purpose of today's webcast is to update you on our outlook on emerging markets for the next few months. And essentially, market where we discussed in our two webcasts during Q1 with respect to what we expected for the asset class going forward. To sum things up, we see emerging markets challenged by the occurrence of three different issues or factors. One is the inflationary problems in the US economy and the monetary tightening associated to it. The second one is the high levels of that accumulated by emerging market countries, combined with what we expect to be a structure slowdown in Chinese activity. And finally, the fact that valuations haven't yet quite got to levels that properly compensate for the risk. What we see in this chart on the three lines at the bottom is the evolution of the size of the balance sheet of the Fed in light blue, the ECB in yellow, and the Bank of Japan in red over the last few years. The green line on top shows the combined size of the balance sheet of those three central ones.

And what you can see here is that between the end of February 2020 right before the COVID issues accelerated, on the end of 2021, the combined balance sheet of the three large central banks increased by total size of approximately eight and a half trillion dollars over seven quarters, which is roughly equivalent to a $5 trillion annualized rate of a balance sheet growth or liquidity injection. It's important to have some perspective for the magnitude of $5 trillion annualized of a balance sheet growth, because it is roughly equivalent to a bit more than five times the amounts of stock repurchases in the US economy in any given year. In the last five years, it's three and a half times the size of the market cap of the US high yield corporate bond market, or you can view it as seven to eight times the amount of dollar-denominated issuance annually by emerging market sovereigns and corporates. This liquidity injection came to almost a full stop by mid-March, and starting on June 1st, it is actually going in reverse.

And the main consequence that this is going to have is that those private institutions during the years of quantitative easing were being forced to direct their organic inflows into risk assets, which operated as substitutes for government bonds that were being purchased by the central banks will now be able to redirect a part of those inflows back to government bonds the way they used to do before quantitative easing came into full swing. And this is going to starve all those risk asset classes that operated as substitutes during the years of QE from capital. And we're already seeing the direct consequences of this in emerging markets. In the slide that we're sharing here where the bars show the amount of dollar denominated bond additions by emerging market sovereigns and corporates in the first five months in each one of the last six years. And we see that year to date, total EM issuance is down by about 50%, but the issuance of the HY segment of the asset class has fallen by 53%, and it's at the lowest levels we have seen in the last six years. We believe that this trend is going to continue.

And as those weaker credits run out of their cash buffers, we're going to see a significant increase in the default rates, both the sovereign and the corporate level. And we don't think that market is quite coping with that reality yet. If we move on to the next one, we can begin to discuss the second issue that we feel will be a challenge for emerging markets. In this chart, the light blue line in the middle shows the median level of data debt as a share of GDP for the countries in the emerging market universe that we track on a daily basis. The lowest levels of debt were reached right around the time of the global financial crisis. And from that point on, asset terms of trade for these countries deteriorated over time as China began to slow down, due to the fact that because of quantitative easing, the government of these countries were able to fund their spending.

Most governments in emerging markets continue to spend at record levels as a share of GDP, accumulating significance amounts of debt over the following 12, 13 years. The red line on top shows that the top quartile of most indebted countries in our asset class has already levels of debt to GDP that is close to 80%. We believe that the majority of these countries are now in a situation where they will be forced to restructure their debt. There's a small number of countries in this group where that debt is denominated in local currency. And in those cases, some of these countries will have to probably restructure the local debt, or alternatively, they're going to have to inflate that way with currency depreciation and acceleration of inflation. So this is the main issue associated to levels of debt in a context where the funding is becoming scarcer. The second issue which we describe in the following slide is that this accumulation of debt has crowded out the investment. The light blue line on the right side of the slide shows annualized investment growth year over year.

You can see here that we're going back to the rates of investment growth that we had in the early 90s before the majority of these countries restructured their debt. The first consequence of this deceleration in the rate of investment is visible on the chart on the left side, where the light blue line shows GDP for emerging market countries in the last 20 years. And the yellow line shows GDP growth for developed market countries. In the late 2000s when the levels of debt for EM countries were at their lowest point and investment was at its strongest pace of growth, there was a significant gap in GDP growth between emerging market countries and developed countries. As investment was crowded out by debt, you can see that GDP growth gap essentially went away. In a way, the more in debt a country is, the more it is likely to fall into a vicious cycle where due to lack of investment, particularly in the export sector, whenever the domestic economy accelerates improving the path of debt to GDP, these countries would run into imbalances in their external accounts because they don't have enough export capacity.

And the chart we're sharing here essentially proves that point to some extent. The blue line with the red dots show the areas really valuation for the currencies of the countries that are part of the emerging markets local debt index versus the US dollar in real terms. As you can see for the last six years, EM currency evaluations have been very, very attractive, very cheap. Nevertheless, when one looks at the yellow line that shows the current account balance as a share of GDP for the countries in EM local bond index. One sees that, for example in 2017, when these economies began to reaccelerate after the significant contractions that they experienced between 2013 and 2015, the current account balances, which have managed to go into equilibrium due to the contraction of the 2013 to 2015 period, very quickly go back into imbalance.

And again, we see this development happen right after the COVID shutdowns. The improvement in the current account balances that we see in the first half of 2020 happened when these economies were shut down because of COVID and imports essentially were frozen. The moment these economies reopen and reaccelerate, even when they reaccelerate fairly slow levels of growth, we see the current account balance collapse. And there's only one solution to this problem, which is to either reduce the levels of debt via an improvement in fiscal dynamics, or alternatively, via a restructuring of the debt for the most indebted countries.

This challenge of not being enabled to keep current account balances in equilibrium, if and when growth rates accelerate for the domestic economy, it's going to be further complicated by the fact that one of the main buyers of products from emerging market countries, which is China, is actually going to run at a much lower rate going forward. And the biggest picture, easiest way to try to explain this, is by using these charts that we're now sharing. When one look looks at the chart on the upper right, for example, which the yellow dots shows the level of investments as share of GDP for South Korea between 1977 and 2007. And the blue dots, it shows the annual GP growth rates for that period. In the 1970s and 1980s, when Korea goes from being a medieval economy in terms of how modern its production systems were, to a 20th century industrial economy, each unit of capital that gets invested on the margin has significant productivity.

And with low levels of capital investment, the economy was able to grow at very high rates. You can see here that it grew between eight and 14% annualized for a long number of years. Now, any country that manages to go from poverty to middle income and to grow at high single digit or low teens, in terms of GDP growth for a sustained number of years, end up facing what's called the middle income trap, which is the point when you have more natural economy, to such an extent that additional units of capital investment have diminishing marginal productivity. When the majority of these types of economies gets to that situation, the first instinct in policy makers is to increase investment to try to keep growth running at high rates that they have become used to, but accumulating high levels of investment where the marginal productivity could now start to become even negative means that the economies are accumulating significant imbalances, that when faced with an external shock, they are forced to adjust. In the case of Korea, that external shock was a currency crisis in Thailand and Malaysia in 1997.

And you can see in the chart that from '98 on, there's a significant drop in investment as a share of GDP. And for the following 10 years, the average rate of growth for GDP essentially runs at roughly half over in the case before. The same thing happened with Japan in the 60s and 70s. In 1973, the oil embargo was the external shock that forced Japan to adjust down investment. And the same thing has been happening with China, where investment began to get significantly increased in the second half of the 1990s in order to keep growth running a very high levels. But already by 2018, 2019, we're seeing the Chinese authorities attempting to reign on those areas of the economy where growth had been too substantial and marginal productivity wasn't really there. And then we get this COVID hit. I mean, we already know that growth has decelerated, and when the World Bank puts out the data, we're going to see that investment has probably fallen.

And if you can now go onto the next slide, we can see here on the chart to the left that the base of growth in China is very, very slow. The yellow line shows the official GDP numbers. The blue line is a high frequency estimate of annualized GDP growth on a rolling three month basis. And you can see here that over time, this high frequency estimate has been around the official number, which is much smoother because it gets reported, I mean, annually at the end of a quarter. But if economy is in contraction and even in the couple of years before COVID affected China, the efficacy estimate was shown that growth was running a significantly lower rate than have in the case before. We believe that these lowest rates of growth are going to continue in the future. And they may be manageable for China, but a lot of the demand that came from China for emerging market products is not going to be there in the future, and this is going to be an additional help.

And now finally, if we move on to valuations, it doesn't appear to us that valuations in general in EM have caught up with the reality that we're describing. The table on the right side of this slide shows the spreads overlie in 5 year CDS. For a number of countries that are investment grade rated, and even a country or two that being higher rated, we think that are likely to be able to pay back their debt without much problem. That will spread over for those countries 109 basis points. If an investor takes exposure to CDX IG, which is five year credit risk in US high grade, the pickup in EM is only 20 basis points. And the table shows that when these assets get to their widest levels of spread over the last 10 years in the case of EM, that spread can grow by a factor of 2.5, 2.6 times.

Well, in the case of US IG, that spread grows by a factor of two times. So one or the other point where EM valuations appear to compensate for the risk, even more difficult the argument is to make for the high yield component of the asset class in our view, given the risk of an acceleration in default rates that we've already mentioned. And on the local side, if we're going to go on to the next one, it is true that there's been a significant amount of currency depreciation and a significant amount of tightening by emerging market central banks. But what we can see here is that inflation has been accelerating at a speed that actually was higher than that, which central banks have entitled in policy. A year ago, the one year out as inflation for the emerging market countries in the local one index was about 3.1%.

When we made the estimate in late May, it was at 8.4. It had almost three... And on the right side, we see the real rate estimated by subtracting the last year of inflation from our net rate. And we see that crude estimate of the real rate has actually gone even more negative. If one looks at the yield in the emerging markets local bond index, taking China out, and we take China out because it would bring the yield even lower. We don't think that it's fair with a currency that is quite managed and a capital market that is quite close. Still, ex China, the last year worth of inflation is out 120 six months ago, where the yield on the indexes with almost five years in duration. So to conclude, we think that we shouldn't be expecting a liquidity driven rebound ahead of us because the inflationary picture in the US is not going to allow the Fed or other central banks to come and rescue financial markets the way we've been used to when the challenge faced by central banks was hitting the zero lower bound.

We believe that there's a good portion of our asset class, call it 60 to 70%, that has some balance sheets and fiscal dynamics that will allow them to adjust to what we expect to see over the next few years. But there's a good portion of the asset list, particularly the most indebted portion, that 25% or so where debt to GDP's in excess of 80% where the default rates are going to substantially increase. And the key there will be to be able to identify those countries that can turn around on their own if they could, or they're large politically important enough for the US and Western Europe to actually get the support and the discipline and mechanisms associated to the programs suggested by the IMF and other multilateral institutions.

We think that there, there will be opportunities to make a return that will be correlated with what you could see in developed capital markets, particularly because of that multilateral discipline mechanisms. And the fact that geopolitics is a consideration that is not usually applicable to develop market corporates, for example. It will be also quite important to have the ability to avoid those countries where restructurings are going to take place and capital will be wiped out. So we still see another leg of volatility in our asset class, but we also believe that we're getting to the end of the process, and opportunities are going to be much more balanced going forward. With this, I wanted to thank you for joining us today. If you have any questions regarding our outlook or anything related to our strategies, please feel free to contact your sales rep at Man and we'll get back to you.

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