Debunking the dislocation

18 Mar 2020

10 Minutes

Local currency debt

Authored by Mike Hugman, Portfolio Manager

18 March 2020

The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole. 

Key points

  • The market reaction to the coronavirus and oil price crises has led to a severe dislocation between asset prices and fundamentals in some local currency bond markets.
  • Several case studies illustrate the magnitude of these dislocations – long-term investors should remain focused on the fundamentals.
  • While risks remain, we expect policy action and the IMF to provide important and effective support.
  • Real yields are now at record highs relative to developed markets, while many markets are attractively priced relative to our structural yield models for the first time in several quarters.
  • The market dislocation is creating some historic opportunities for investors with the right expertise in pursuit of alpha.

The twin tail risk events of coronavirus (COVID-19) and the failure of the latest OPEC+ agreement have led to a widespread liquidity event across global markets and spanning most asset classes.

The result is pronounced dislocations of asset prices relative to underlying fundamentals. In local bond markets, we have seen this most starkly in Russia and Peru. There – and elsewhere – market moves are creating historic potential future return opportunities, in our view.

Meanwhile, we think that the recent outperformance of Chinese local bonds highlights the importance of Chinese bond market integration as a means of providing investors in emerging market local bonds with a strong, investment-grade market; one that entails low liquidity risks and offers low correlations to other global assets.

While risks remain around the impact of coronavirus and low oil prices, we view both as temporary shocks, even if they could persist for some time and could cause further downside to risk assets. Coordinated monetary policy action, fiscal measures and support from the IMF are all likely to provide some support for emerging markets and help them to withstand a three-to-six-month shock, in our view. This is particularly true in local currency bond markets with strong fundamentals and long-term sources of local investor support.

Russia

In response to a challenging period over recent years, led by geopolitics, Russia has undertaken unprecedented steps to anchor its macroeconomic framework. Inflation is at historic low levels, below the central bank’s target, while the country’s twin fiscal and current account surpluses are at historic highs.

Despite the fall in oil prices and disagreements within OPEC+, we believe Russia can maintain its current fiscal policy for several quarters, drawing on its exceptionally high levels of savings, without its debt/GDP approaching a level that would put its investment-grade credit rating at risk. 

Peru

For many years Peru was an outlier in emerging markets, operating an economic model which emphasised only partial floating of the exchange rate and accumulation of larger foreign exchange (FX) reserves. This was due to its history of crisis and continued partial dollarisation of the economy and led to an exceptionally strong inflation outcome for the central bank, at or below its 2% target.

Prudent fiscal policy has resulted in very low levels of debt/GDP, and Peru’s current fiscal spending can be financed from savings for several quarters, by our estimates. Yet on 16 March we saw the largest one-day increase in the JP Morgan index yields in history; a move that we think is wholly out of line with the country’s long-term fundamentals. 

China

The entry of Chinese local bond markets into JP Morgan’s flagship suite of emerging market debt indices has only just started. But our conviction – based on the asset class’s low correlation to global markets, the lack of short-term positioning among the existing investor base, together with China’s effective response to the original coronavirus outbreak – gave us the confidence to maintain a sizeable overweight in Chinese currency and local bonds.

We think that the recent outperformance of Chinese local bonds highlights the importance of Chinese bond market integration as a means of providing investors in emerging market local bonds with a strong, investment-grade market; one that entails low liquidity risks and offers low correlations to other global assets. 

Opportunities elsewhere

In addition to the highly distressed names discussed above, there are a number of other opportunities that we believe look attractive. In Israel, for example, heavy positioning by non-dedicated emerging market investors has led to a mass exodus, pushing 30-year yields towards levels last seen in mid-2019 before the Federal Reserve started cutting, and local real yields are back above 2%. In Korea, similar indiscriminate selling has taken spreads to US Treasuries wider than at any point in the last five years.

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Hard currency debt

Authored by Mike Hugman, Portfolio Manager

16 March 2020

The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole. 

Key points

  • The market reaction to the coronavirus and oil price crises has led to a severe dislocation between asset prices and fundamentals in some hard currency bond markets.
  • Several case studies illustrate the magnitude of these dislocations – long-term investors should remain focused on the fundamentals.
  • While risks remain, we expect policy action and the IMF to provide important and effective support.
  • The market dislocation is creating some historic opportunities for investors with the right expertise in pursuit of alpha.

Ecuador

The bond market is now pricing in a debt restructuring as severe as the debt repudiation undertaken by Ecuador’s hard left government in 2009. But Ecuador is a very different economy to the one it was ten years ago.

Today, debt/GDP is 50%, with interest/revenue of only 17%. The country is also now in an IMF programme (albeit with minor current delays) and has no major bond maturities until March 2022.

Furthermore, the current government is strongly committed to reform, even though it has faced some challenges in areas like fuel subsidies. And it has already announced measures to balance the budget in the face of lower oil prices.

The major medium-term risk is the presidential election next year, with at least one radical left-wing candidate expected to run. However, Ecuador’s fundamentals are vastly different to what they were in 2009 and we believe market pricing is ignoring this fact.

Angola

We see significant price asymmetry in Angolan hard currency bonds as we believe the risk of any restructuring within the next 12 months is low.

After the 2015 oil price shock, Angola engaged in significant fiscal and economic reform supported by the IMF. Since then, it has reduced its non-oil primary deficit by almost 40% and moved the fiscal breakeven oil price from the high 80’s to the low 50’s.

We also expect that the government will have enough levers to consolidate fiscal balances even further to counteract the impact from lower oil revenues. In addition, the government has several funding sources available should the market remain shut for Eurobond issuance, which could cover gross external financing needs over 2020.

The current government in Angola continues to show resolute progress towards changing the face of the country after the Dos Santos era.

Zambia

Concerns around Zambia’s spending and fiscal profligacy have kept us on the side-lines for almost two years, but over last 12 months we’ve seen significant changes which we believe were being underappreciated by the market even before the latest sell-off.

Firstly, we see the country making a strong move closer to the IMF and a clear recognition from the new finance minister on the need to deal with main fiscal issue in Zambia, which is agreed but not yet disbursed external infrastructure-related loans. To that end, Zambia has announced that it is cutting US$5 billion from the US$7 billion pipeline, which - along with measures already taken on electricity prices - should be enough to ensure fiscal sustainability.

Secondly, we see very high willingness to pay as well as continued ability as we head into the August 2021 elections. We believe that for investors this means getting paid yields in excess of 40% to hold an asset which should continue to be serviced with upside from further economic reforms. But the market is painting a much more negative picture.

Opportunities elsewhere

In addition to the above, we believe some other markets are now looking particularly attractive, prompting us to increase or initiate positioning across our strategies. In Russia, for example, heavy positioning by non-dedicated emerging market investors has led to a mass exodus, pushing spreads towards levels last seen in 2015/2016 and local real yields above 5%. In Ukraine, similar indiscriminate selling has taken spreads to the highest levels since the 2015 restructuring.

We believe that with the right process and team behind them, investors can take advantage of these opportunities in pursuit of alpha in coming quarters.

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Sovereign debt - keeping fundamentals in firm focus

Authored by Peter Eerdmans, Head of Fixed Income

10 March 2020

What's happened?

Against the headwinds of collapsing demand, OPEC and its allies met to discuss further cuts to oil production. While Saudi Arabia led the push for additional cuts of 1.5 million barrels per day (bpd), Russia strongly resisted this, citing the need to undermine the US shale industry. The meetings ended in failure, not only to agree to further cuts but also to extend the current 2.1 million bpd cuts beyond the end of March – something the Russians were willing to agree to. 
Over the weekend, Saudi Arabia – probably in an attempt to convince Russia to come back to the negotiating table – lowered prices on April loading and suggested it could dramatically increase production.

The result has been a collapse in oil prices, with Brent crude trading in the mid-30s at the time of writing – down from US$45 at Friday’s close and US$66 at the start of the year.

With coronavirus already weighing on market sentiment, the oil shock has compounded volatility, with a sell-off occurring across equity, currency and credit markets, and US Treasuries rallying even further into record low yields.

What next?

While the failure of OPEC-Russia co-operation was a not a complete surprise – tensions had been building for months, if not years, as Russia was perceived to be free-riding – the timing couldn’t have been worse, given the coronavirus-induced collapse in demand for oil.

This combined demand and supply shock is the worst we have seen for many years. We think that oil prices could fall below US$30, and – in the absence of further intervention – remain low; there is a significant excess supply of the commodity and demand for it could take some time to recover fully if the coronavirus outbreak persists into the early summer.

We cannot rule out a quick U-turn by OPEC and Russia. The outcome of the OPEC+ discussions was sub-optimal for both parties – both have an incentive to try and stabilise the oil market at a higher price.

However, the Russian finance minister saying the country can withstand oil prices in the region of US$25-30 for the next six to 10 years, does not bode well for a near-term rapprochement with Riyadh. Moreover, the demand outlook is looking increasingly challenging as coronavirus spreads through Europe and the US – the International Energy Agency just lowered its demand forecasts significantly, foreseeing the first full-year contraction since the global financial crisis. Therefore, we expect a significant excess supply of oil through the second quarter.

Outside of the oil market, the risks to the global economy from coronavirus remain significant. While it is still difficult to gain conviction on the exact future path of the outbreak, it is likely to get worse and the impact on the global economy will likely be more protracted than that associated with a sharp V-shape plot of economic activity.

The market reaction on Monday has been significant, with high-yield oil and currency markets the worst hit in our asset class

Implications for our strategies

Hard currency sovereign debt

Sovereign debt of oil exporting nations with a high-yield rating has been badly impacted, with bond prices down 6-10 percentage points at the time of writing.
The most vulnerable name we own is Ecuador, which had already seen its bond market fall by around 35% from January highs, largely on idiosyncratic headlines. Oil revenues are important for Ecuador’s fiscal health. However, we expect it to be able to adjust and finance itself, supported by the IMF and a continuation of prudent macro policy.

Given its heavy reliance on oil exports for external and fiscal receipts, the Angolan economy will also be negatively impacted by much lower oil prices, but we expect to see a revised budget and increased multilateral support to reduce the burden on this economy in the short term. We retain our overweight positioning.

We are also overweight Ghana. Although it’s an oil exporter, Ghana has a much more diversified export base compared to its peers and oil makes up only a small part of government revenues. Growth dynamics are also positive for the country’s bonds and so we retain our positive long-term outlook for this market.

By contrast, we are running a sizeable underweight to Middle East oil names and other high-yield African markets, such as Nigeria and Gabon. We have no exposure to the high-yielding markets of Oman, Bahrain and Iraq, which are among the most sensitive markets to oil. We continue to prefer investment-grade exposure in Saudi Arabia and Qatar, and we have zero weights in the United Arab Emirates and Kuwait. Saudi Arabia is the most oil-sensitive of these and has sold off significantly in Monday’s trading. However, given the size of Saudi Arabia’s gross foreign exchange assets, we believe it can withstand lower oil prices for some time.

Local currency sovereign debt

In local markets, the main oil-linked currencies are down around 7 to 8% on the day at the time of writing. Local rates in oil markets, in particular, have also backed up in the sell off. Our main oil-exposed positioning is as follows:

We have an overweight in the ruble and are also overweight Russia rates. As we have highlighted in the past, Russian economic fundamentals remain very solid, even with oil prices at current levels. Since the 2015 oil collapse, Russia has taken painful steps to: reduce its non-oil fiscal deficit (from -15% to approximately -5%); run an overall budget surplus; build its FX reserves (from a low of US$360 billion in 2015 to current levels of US$570 billion); and bring down inflation to below 3%. Therefore, it’s not surprising that the Russian ministry of finance stated on Monday that the country could withstand oil prices of US$20 to US$30 for the next six to 10 years – a positive for Russia, but perhaps not for oil markets in aggregate, if Russia chooses not to re-engage with OPEC. Based on these strong fundamentals, we are confident to keep this risk in our strategies and we generally prefer to manage our oil exposure through other, structurally weaker, countries.

Our Russian exposure is offset by an underweight in the Colombia peso, given its recent outperformance and its exposure to oil prices. We are neutral Colombia’s local bond market, although we do see value in the long end of the curve.

We are neutral the Mexican peso, having cut our overweight a couple of weeks ago. Although we are also neutral the local bond market overall, we are slightly underweight nominal bonds while holding a small position in inflation-linked bonds.

We are short the Nigerian naira where we see a poor risk-reward ratio and rising devaluation risks. Elsewhere in Africa, we continue to like unhedged Ghanaian bonds, with yields over 20% and positive debt sustainability dynamics.

Emerging Market Multi-Asset

In the equity portion of our Emerging Market Multi-Asset Strategy, we are long Chinese equities and underweight broader emerging market equities, as we expect China to recover from the coronavirus before the rest of the world and believe a lower oil price will be supportive for Chinese companies.

As always, we are actively managing risk in our strategies, seeking to take advantage of market mispricing within the wider sell-off.

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All investments carry the risk of capital loss.

Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.

The value of investments, and any income generated from them, can fall as well as rise.

General risks: The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.



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