Fixed Income BOTTOMING SENTIMENT CREATES OPPORTUNITIES IN EMERGING MARKETS DEBT

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1 FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION. PRICE POINT March 016 Timely intelligence and analysis for our clients. Fixed Income BOTTOMING SENTIMENT CREATES OPPORTUNITIES IN EMERGING MARKETS DEBT EXECUTIVE SUMMARY Michael J. Conelius, CFA Portfolio Manager, Emerging Markets Bond Strategy Sentiment toward emerging markets debt seems to have bottomed at the beginning of 016, providing an attractive entry point for investors who want to take advantage of compelling valuations amid potential for structural reforms in some developing countries. Uncertainty about China s currency policy and OPEC s oil production decisions will likely prolong the volatility in emerging markets currencies, leading us to favor dollardenominated sovereign bonds. Within that segment, select bonds from Argentina, Brazil, and Mexico offer compelling valuations and opportunities to benefit from ongoing or future reforms. SENTIMENT APPEARS TO HAVE BOTTOMED OUT Emerging markets debt investors endured a meaningful performance downturn in late 015 and early 016, both outright and relative to bonds from developed markets. In early January, sentiment toward the asset class and news headlines about emerging markets in general were almost universally negative. While continuing uncertainty about China s foreign exchange policy and OPEC s oil production decisions make the outlook for emerging markets currencies murky over the near to medium term, market sentiment toward dollar-denominated emerging markets bonds may have reached a bottom in mid-january. Taking a contrarian point of view, this overly bearish environment has created compelling opportunities to add to positions in the hard currency sovereign sector. In this environment, countries with idiosyncratic reform stories or that have made progress with external adjustments hold the most appealing prospects. INVESTMENT-GRADE SPREADS VS. U.S. CREDIT REACH WIDEST POINT IN OVER FIVE YEARS The global risk aversion that permeated markets at the beginning of 016 resulted in credit spreads on investment-grade dollar-denominated emerging markets debt

2 reaching their widest point in five years relative to U.S. investment-grade bonds. The yield on the benchmark J.P. Morgan Emerging Markets Bond Index Global surpassed 7%, reaching the highest absolute level since the end of the global financial crisis in 009. While BB rated emerging markets debt trades at a tighter spread than similarly rated U.S. high yield bonds, this likely results from the energy-related distress in U.S. high yield, where oil and gas producers represent a large share of the market. After several years of significant inflows following the end of the global financial crisis, retail investor outflows from emerging markets debt dominated 015, and some strategic institutional investors joined them late in the year. It s also likely that the sovereign wealth funds of nations that are major commodity exporters have been exiting their positions in emerging markets bonds as they raise cash to prop up their national currencies and offset their plummeting revenue from exporting oil and other commodities. Given these technical factors, it appears increasingly likely that negative investor sentiment toward the asset class has dragged prices down to levels that do not reflect the intrinsic value of some sovereign issuers. UNCERTAINTY ABOUT CHINESE FX POLICY CLOUDS OUTLOOK There are two crucial top-down factors that currently dominate risk markets: China s foreign exchange policy and OPEC s oil production decisions. Until we gain clarity on those policy fronts, we are unlikely to see durable stability in emerging markets currencies. China continues to contend with the impossible trinity of open capital markets, a fixed exchange rate, and independent monetary policy. A country can only sustainably maintain two of these regimes at the same time. As its growth slows, China should continue to ease monetary policy. The inexorable globalization and sophistication of capital markets reinforces China s active desire to open its financial markets to foreign investors. So the weak link is the pegged, or managed, yuan exchange rate versus the U.S. dollar. This unbalanced equation is no secret speculators have leaned against the offshore yuan rate and interbank rates in Hong Kong, and capital flight from China has accelerated. In direct contravention of a key lesson learned by other emerging markets about conserving foreign exchange reserves, China is burning through its reserves to support the yuan. While recent statements from the People s Bank of China (PBoC) have assuaged near-term concerns, a further Chinese yuan devaluation appears inevitable. We believe that it would be best for China to act from a position of strength while it still has ample reserves so that it can respond to any collateral damage in its local government, corporate, or banking sectors. Doing so would eliminate the uncertainty in the market about the timing of such a move. The currency s overvaluation is not extreme, but an additional devaluation of 10% to 0% would have a meaningful knock-on effect on most emerging markets currencies, particularly those of other Asian developing nations that trade with China. We welcome the calming words from the PBoC but remain cautious within emerging markets currencies. LOW OIL PRICES EXCESSIVELY PRESSURE RISK SENTIMENT OPEC policy is somewhat analogous to China s intransigence on devaluing the yuan. Saudi Arabia s decision to maintain its production levels to bankrupt higher-cost producers relies on the financial staying power deposited in its sovereign wealth fund. There are, of course, political dynamics at work as well notably, Saudi Arabia s apparent intent to mitigate Iran s reemergence as a major oil producer with the removal of Western sanctions. In fact, Saudi Arabia and other Persian Gulf nations are operating in their own impossible trinity of sorts, involving pegged foreign exchange rates, collapsing primary exports, and massive expansion in structural fiscal deficits. Technological advances in oil production especially fracking are leading to oil service-cost deflation and higher initial production runs. With each cycle, this lowers the breakeven price for marginal non-opec producers, while fiscal largesse increases the breakeven price in the Gulf states. Saudi Arabia may be winning the battle (the U.S. oil rig count is down more than 70% from its peak), but it may lose the war. Weak oil prices will continue to set a bearish tone for risk assets until there is a marginal reduction in global supply. Nonetheless, in recent days, a tentative agreement on capping (but not reducing) oil supply has PRICE POINT

3 catalyzed a bottoming in crude oil and emerging market debt. There is an asymmetric impact on risk appetite as the losers from low commodity prices matter more for performance than the winners. Figure 1: China, Oil, USD Strength, Emerging Market FX (EMFX) Weakness Secular slowdown, demographics Peak in commodity intensity; rotation to services Confused FX policy transition China Oil Saudi/OPEC oil policy; Iran/Iraq supply U.S. supply Deflationary services (lower breakeven price) Supply price inelasticity EMFX weakness USD strength Cyclical and secular growth slowing Procyclical policy Hurts growth, rates, EMFX, spreads Weaker commodity prices Capital flight from Chinese yuan U.S. Fed normalization USD carry advantages Source: T. Rowe Price. TECHNICAL AND FUNDAMENTAL FACTORS FAVOR HARD CURRENCY SOVEREIGN BONDS This macro environment leads us to favor hard currency sovereign debt over locally denominated or corporate bonds from developing markets. Since the end of 01, the growth rate of outstanding hard currency debt has slowed significantly as governments have increasingly opted to fund themselves in local currencies, creating a scarcity premium for external debt. Russia, Brazil, Venezuela, and some other countries have faced challenges issuing new bonds as a result of economic distress, further restricting supply. In addition, dollar-denominated emerging markets sovereign debt is generally more liquid than corporate bonds from developing countries. The improvement in current account deficits and the still large stock of foreign exchange reserve liquidity lead us to prefer hard currency debt over local market or corporate bonds. Many emerging markets exporters have wisely allowed their exchange rates to adjust to the downside to reduce external imbalances. While painful for local currency investors, this adjustment has allowed many of the fragile five countries of Brazil, India, Indonesia, South Africa, and Turkey to reduce their dependence on global capital flows. As opposed to making judgments about broad market segments, the Emerging Markets Bond Strategy has historically approached the local versus hard currency decision as a question of security selection: Where is the best value or risk-adjusted return potential in a given country? With the cyclical headwinds developing currencies face, we believe allocations to local markets are best expressed via defensive positioning and through intraemerging markets funding. As these headwinds ease, local currency debt will offer a more attractive investment proposition. Although corporate bonds are an important driver of excess returns for our Emerging Markets Bond Strategy from a long-term, structural perspective, we currently have a cyclically diminished allocation to the corporate sector. This lower allocation to corporates results from the thin liquidity in this younger asset class, crossover selling pressures from the U.S. high yield segment, and some fundamental credit deterioration from higher leverage and exposure to weaker growth and currencies. As these issues cyclically dissipate, we are likely to increase our PRICE POINT 3 3 3

4 Percent of GDP (%) allocation to emerging markets corporate bonds, relying on the deep collaboration between our dedicated emerging markets equity and debt analysts, portfolio managers, and traders. Figure : Current Account Deficits as Percentage of GDP 0 Turkey CAD% GDP India CAD% GDP Brazil CAD% GDP South Africa CAD% GDP Indonesia CAD% GDP Dec 011 Dec 01 Dec 013 Dec 014 Dec 015(E) Dec 016(E) Dec 017(E) Source: IMF World Economic Outlook as of December 31, 014. IDIOSYNCRATIC DEVELOPMENTS OFFER LONG-TERM OPPORTUNITIES Crisis periods are often the strongest inducement for countries to make real structural reforms. Negative headlines about weakness in China and in oil prices have obscured some significant progress that buoys future prospects. For example, the reformist victory in Argentina s October 015 elections is helping to usher in a return to normal relations with the country s creditors and the correction of longstanding macroeconomic imbalances. While expectations for increased bond supply mean that returns in Argentina are unlikely to repeat the strong gains of 015, we have seen a number of supportive reforms enacted. These include a reduction in expensive energy subsidies, successful negotiations with holdout creditors, and an exchange rate devaluation. Brazil has experienced a correction in yields amid an extended period of weak growth, rising unemployment, stubborn inflation, and political paralysis. With most negative catalysts already priced in and investor positioning now more balanced, we believe the country s hard currency sovereign debt offers an attractive carry and yield premium. Brazil s foreign exchange reserves exceed its hard currency debt outstanding, which is encouraging. Also, while the impeachment of President Dilma Rousseff remains highly uncertain, a reform-oriented administration coming into power after Brazil s 018 elections could prompt a quick turnaround in the country. In contrast with Brazil and Argentina, Mexico s challenges are modest. We continue to like the outlook for its bonds as the Mexican government steadily pursues significant reforms. This was most recently evidenced by the coordinated policy moves in February that included a 50-basis-point policy rate hike, a move to discretionary foreign exchange intervention, and fiscal cuts. Within Mexico, we have a meaningful bias toward bonds issued by Pemex, the state oil company, as we believe the credit has suffered unduly from weak oil sentiment. Both Mexico and Pemex have implemented reforms and capital structure changes that are long-term positives for their credit quality. We recently shifted much of our holdings of bonds denominated in Mexican pesos to dollar-denominated Mexican sovereigns that we believe offer better relative value. PRICE POINT 4 4 4

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