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EM credit: from top to bottom, signs point to a strong 2019

After last year’s volatility, top-down and fundamental factors support robust credit performance in emerging markets.

Key points:

  • Political and economic ‘micro-events’ are becoming contained
  • Global GDP-growth leadership is shifting to emerging markets
  • A solid outlook for commodities, expected capital flows and the prospect of ESG reforms also point to a bright 2019

Emerging market (EM) credit could take over global growth leadership this year as pockets of volatility subside, revealing promising corporate and economic factors.

Political and economic events troubled certain EMs last year, including the elections of non-establishment candidates in Brazil and Mexico1. Financial crises in Argentina and Turkey also spooked investors.

Despite these roadblocks, corporate bonds outperformed government and local-currency bonds in EMs, with corporates losing 1.2% compared to 4.3% in sovereigns and 6.2% from local-currency instruments. This was accompanied by continued improvement in the underlying fundamentals of corporate bond issuers in these markets.

In addition, political and economic EM events are becoming more contained. No longer is it the case that trouble in one country quickly spills over into another, with the ‘mini-crises’ of last year failing to impact EM credit spreads in general.

Figure 1. Broad emerging-market credit indices verses individual markets

Source: Hermes Credit as at 31 December 2018.

EMs: the global growth engine of 2019?

Global-growth leadership should swing in the favour of EMs in 2019 as progress in the US economy moderates. The International Monetary Fund expects the growth differential of EMs relative to developed markets (DMs) to increase from 2.3% in 2018 to 2.5% this year, and to rise further to 3.2% in 20202.

Significantly, this outperformance has shown a strong positive correlation with EM capital flows as a percentage of GDP, and we expect that trend to continue this year.

Figure 2. Correlation: the outperformance of EM economies and capital flows as a percentage of GDP

Source: J.P. Morgan, Hermes Credit as at December 2018.

Moreover, two additional factors should support EMs credit this year. First, the stabilisation of US interest rates amid the Federal Reserve’s likely pause in its monetary-tightening cycle, will make EMs more attractive. Second, as US growth converges with that of other major economies, the value of the dollar should decline in synch and benefit EMs.

What about the trade war?

US-China trade negotiations seem more likely to produce a positive outcome than a few weeks ago, with the base case of Silvia Dall’Angelo, Hermes Senior Economist, being that there will be a positive resolution – albeit possibly a temporary one.

Even if the discussions continue, we believe that any impact on the Chinese economy will be partly offset by domestic policy stimulus and a depreciation in the Chinese yuan.

If the US were to increase tariffs on Chinese imports, this could drive up production costs in China and compel manufacturers to invest in other locations. Importantly, however, overall foreign direct investment is likely to stay within the EMs.

The influence of commodity prices

While volatile, commodity prices have been on an upward trend so far in 2019 and the markets remain tight.

Oil is still well supported by OPEC’s prudent policy of restraining supply levels to keep prices higher. At the corporate level, the overall shift in strategy by US producers to focus on cash flows instead of investing for future growth is constructive3.

But commodity markets are not just about energy. Copper and steel inventories remain low by historical standards and are likely to be replenished.

In many instances we also think there is an important distinction to be made between the fundamental prospects of commodity-exposed government bond issuers and commodity-exposed corporate issuers.

For example, governments of oil-exporting countries have been increasing their indebtedness while the oil price has been recovering. Meanwhile, corporates which are exposed to oil have been deleveraging and, we think, will be better able to manage commodity-price volatility in the future.

Figure 3. Oil-exporting governments have let their debts rise but oil prices have fallen…

…But at the same time, EM oil and gas companies have reduced their debts

Source: Barclays, Bloomberg, Hermes Credit as at December 2018.

Technicals, leverage and ESG

Three further factors convince us that EMs are worthy of investors’ attention.

First, EM credit markets have grown so quickly that the asset class now stands near $1.5tn in total, with more than 700 issuers from 55 countries. Many investors continue to be underinvested in the space4 and are therefore likely to increase their allocations in order to better diversify their portfolios. These flows should provide technical support for EMs over the next 12 months.

Second, in many situations, companies issuing EM corporate bonds offer higher-quality fundamentals, both in terms of leverage and liquidity, than their developed-market peers. Specifically, EMs display lower net leverage levels than US markets, with higher cash-to-debt ratios and similar gross margins in spite of these discrepancies (see figure 4 to 6). In other words, the data suggest that EM corporates are generating similar levels of profitability while not incurring the same levels of debt as US issuers.

Figure 4. Global EM net leverage tends to remain significantly lower than the US equivalent

Source: Bank of America Merrill Lynch as at December 2018.

Figure 5. The ratio of cash to total debt is significantly higher in EM than US companies

Source: Bank of America Merrill Lynch as at December 2018.

Figure 6. Gross margins in EMs are broadly similar to those in the US

Source: Bank of America Merrill Lynch as at December 2018.

Third, our experience shows that EMs offer a real opportunity to generate alpha through engagement with company management. There are significant opportunities, through engagement, to close the environmental, social and governance (ESG) gap between companies in the emerging and developed markets – both in terms of the issuers’ real-world practices and standards of disclosure to investors5. This is likely to benefit performance, as our experience and research shows that reduced ESG risk corresponds with lower credit spreads.

Despite these positive attributes, markets price credit in EMs as being more risky than in developed markets, resulting in a persistent and meaningful ‘EM premium’: 50-100bps per turn of leverage for investment-grade bonds and 100-200bp per turn of leverage for high-yield bonds.

Bright outlook

Individual political and economic events in EMs seem to be less influential on investors’ views on the overall sector. Simultaneously, a range of top-down and bottom-up factors – ranging from changing US monetary policy to strong GDP growth, robust credit fundamentals and engagement opportunities – provide reasons to be constructive on EM credit.

  1. 1 “Latin America at the ballot box: a buying opportunity for credit investors?,” by Andrey Kuznetsov, Co-Portfolio Manager across Hermes Credit’s portfolios, published by Hermes Investment Management on 25/10/2018
  2. 2 “World Economic Outlook Update, January 2019: a weakening global expansion,” by the International Monetary Fund, January 2019.
  3. 3 “Back in black: The energy sector’s cash-flow focus is good for credit,” by Audra Stundziaite, Senior Credit Analyst, published by Hermes Investment Management on 23/11/2017
  4. 4 “Beyond borders: breaking down silos in credit,” by Andrey Kuznetsov, Co-Portfolio Manager across Hermes Credit’s portfolios, published by Hermes Investment Management on 18/09/2018
  5. 5 “Petrobras and Pemex: Putting ESG analysis in the oil mix” by Audra Stundziaite, Senior Credit Analyst, and Jaime Gornsztejn, Sector Lead for Industrials, published by Hermes Investment Management on 29/08/2017

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