The performance of emerging market (EM) debt has exceeded investor expectations so far this year, thanks to falling US Treasury yields and the persistence of broadly accommodative global monetary policies and low volatility in the capital markets. While these benign conditions could continue for some time, MFS’ experts Robert M. Hall, Institutional Fixed Income Portfolio Manager, and Matthew W. Ryan, CFA, Fixed Income Portfolio Manager, review the primary systemic, global risks for EM debt, along with the idiosyncratic, country-level events that have dominated the headlines. As valuations stretch and liquidity recedes, the portfolio managers anticipate that the market will increasingly differentiate among EM credits based on the issuers’ fundamental strength.
Global rates and monetary policy
Central banks of major developed markets (DM) have tried to suppress rate volatility and keep rates artificially low, and they have largely succeeded. According to MFS, intervention by the US Federal Reserve has contributed to Treasury yields that are too low given underlying growth trends. If US economic activity continues to improve, and the Fed’s forward guidance takes a more hawkish tone as a result, Treasury yields are likely to rise, creating a headwind for EM debt and other bond sectors.
How EM debt fares in this scenario would depend on the speed and size of the rate movement. MFS is inclined to expect a more muted and gradual move in Treasury yields this year than last year, when the magnitude of the rate spike prompted a wave of selling that pushed EM spreads wider.
Country-level events
Earlier this year, MFS singled out Venezuela, Argentina and Ukraine, which they called the Terrible Three because these markets all hit crisis points at the same time. How does MFS view these situations now?
Venezuela. MFS remains concerned about the ineffectual policy responses to the challenges facing Venezuela. While the devaluation of the bolivar earlier this year could have been a step in the right direction, it needed to be accompanied by fiscal and monetary restraint. Instead, increased fiscal spending and further monetary growth has fed surging inflation.
By nearly every metric, the economic and financial situation in Venezuela continues to show signs of stress and deterioration. Foreign exchange reserves are low, potentially straining the country’s ability to honor its debt obligations. Yet with the risk-on carry trade still in play, the market appears to be willing to accept the government’s market-friendly rhetoricat face value. In the absence of any policy improvements, MFS continues to believe that Venezuelan debt dynamics are ultimately unsustainable.
Argentina. Argentina has defaulted on coupon payments to investors in its foreign-law, restructured sovereign bonds. Though the technical default will likely have adverse implications for the country’s economic and financial conditions, Argentina has indicated a commitment to service its US dollar- denominated debt governed by local law. MFS believes the yields on those bonds offer reasonable compensation given current risks.
As the outcome remains difficult to predict, MFS is watching the ongoing developments and continually reassessing the risks related to this fluid situation. Longer term, one bright spot is the prospect for a more market-friendly regime following next year’s election.
Ukraine and Russia. Tension between Ukraine and Russia has remained high, and the likelihood of a near-term resolution appears remote. The ongoing conflict has a negative impact on economic activity and, by extension, Ukraine’s ability to meet structural targets established in the reform program backed by the International Monetary Fund (IMF). External funding from the IMF as well as the United States and the European Union has provided a critical fiscal lifeline, yet it will almost certainly become necessary for Ukraine to obtain additional assistance. MFS thinks this could increase the risk of a “bail-in,” with private investors forced to share the burden by having a portion of their debt written off.
Even though the Russian economy could be pushed into recession by the economic sanctions, the Putin government may be willing to endure such an outcome to achieve its broader politicaland security goals.
For now, Russian sovereign credit metrics remain quite strong, with a balanced fiscal account, large foreign exchange reserves and a growing current account balance. Recognizing that valuations could widen to the point where they offer reasonable compensation for heightened risk, MFS continues to monitor the situation closely for possible investment opportunities.
Areas of opportunity
Areas of opportunity still exist within EM debt, yet after solid gains in bond prices, valuations in aggregate appear less attractive now than in early 2014, according to MFS’s team. As US dollar-denominated EM sovereigns and corporates have recovered their losses from2013’s “taper tantrum,” risk/reward relationships have become less compelling, leaving MFS with modest expectations for the performance of EM debt for the rest of the year. Nevertheless, they believe that relative to many other fixed income assets, EM debt valuations are not as stretched.
Although local currency EM debt has yet to fully recover from last year’s selloff, MFS believes that EM currencies may have the highest beta to possible global financial turmoil, given their liquidity and the need for additional macro adjustments in certain EM countries.
In their view, with asymmetric risk to both interest rates and credit spreads, as well as geopolitical and idiosyncratic risk, this is an environment that calls for exercising caution when investing in EM debt.