January 2018 Strong fundamentals should continue to drive Emerging Markets High Yield Dimitry Griko CIO, Fixed Income We remain optimistic on Emerging Markets (EM) Corporate High Yield (HY) due to stable fundamentals, relatively attractive yields, low default rates and potential for further spread tightening. Nevertheless, we realize that the market may be vulnerable to increased US Federal Reserve s base rate and the unwinding of Quantitative Easing (QE). However, our base case scenario is that these factors are well-known and will continue to be implemented steadily and predictably to minimize market disruption. We continue to be highly selective and concentrate on defensive and cashgenerative sectors, such as Telecommunications. We believe that the main drivers of EM Debt performance in 2018 will be: Low Defaults High Inflows Manageable Leverage Robust Performance Reasonable Valuations A broad-based economic recovery is underway, fueled by a global rebound in investment and trade. Benign financing conditions, accommodative monetary policies, and the returning investor confidence bolster economic performance. Growth is expected to accelerate in Emerging Markets (EMs) thanks to a strong recovery in commodity exporters. Simeon Djankov, Ph.D. Economic Advisor Although growth in the next two-three years can surprise on the upside, global economic prospects are still subject to downside risks, including the possibility of increased protectionism. Longer-term global economic challenges include subdued productivity growth and the changing nature of work opportunities due to technological advancement. With output gaps closing in commodity-importing EMs, the use of cyclical fiscal policies is becoming less of a priority. EG Capital Advisors is a UK headquartered asset management company whose core expertise is Emerging Markets Corporate High Yield debt. The Emerging Markets Corporate High Yield strategy is characterised by meticulous bottomup credit analysis delivered by an investment team with an average of nearly ten years of experience. EG Capital Advisors aims to achieve superior returns while maintaining low volatility, and believes that an asset class with an inherently higher risk profile must be managed in a conservative fashion.
LOW DEFAULTS We expect continued improvement in EM fundamentals which should be translated into low default rates. Emerging Markets still have a demographic advantage, lower corporate indebtedness and more room to support their economies with respect to Developed Markets (DM) economies. EM Corporate HY is forecasted to show a slight increase to 2% for 2018 from the 2017 figure of 1.7% Defaults are expected to remain in line with US HY. Source: J.P. Morgan, ex. 100% quasi-sovereign issuers, 2018 Outlook 130 113 110 103 90 86 80 70 50 52 50 43 43 31 35 30 14 10 6 11-10 -1-15 -30 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E2018E Annual EM bonds flows, $bn Source: J.P. Morgan, EGCA, 31.12.207 HIGH INFLOWS 2017 was a record year for EM fixed income fund flows reaching $113bn. According to JP. Morgan s forecasts, 2018 promises to be another strong year with $80bn of inflows, and we believe this flow of funds will be supportive for the market. In the case of continued economic outperformance of EM nations versus their DM peers, EM markets should continue witnessing inflows to the sector. MANAGEABLE LEVERAGE We believe that the improvement in commodity prices, broad-based economic recovery and limited debt growth resulted in improved credit metrics at the end of 2017. As a result, we expect that in 2018 both EM gross and net leverage should decrease for the first time since 2011, and remain significantly below those in the US. 6.0x 5.0x 4.0x 3.0x 2.0x 1.0x 0.0x 5.4x 5.3x 4.6x 4.5x 4.3x 4.1x 4.1x 3.7x 3.8x 4.2x 3.0x 3.0x 2.9x 2.4x 2.4x 2.5x 2.6x 2.1x 2.0x 1.6x 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E EM Corporate Gross Leverage US Corporate Gross Leverage Source: J.P. Morgan, Bloomberg, Capital IQ, EGCA, US Corporates represented by S&P 500 Index, 31.12.2017
VALUATIONS The J.P. Corporate EM Bond HY Index (CEMBI HY) spread is fairly narrow by historical standards, closing 2017 at 406 bps, but remaining well above the historical lows of 285 bps achieved in 2006. Furthermore, we believe the spread level should be considered in the context of the level of absolute rates. In 2006, when the CEMBI HY spread reached 285bp, the US 5yr swap rate was 4.91%. At the end of 2017, the 5yr US swap rate was only 2.21%. Consequently, the current CEMBI HY spread level provides a far greater cushion to the risk of higher absolute rates than it did in 2006. 2500 2000 1500 1000 500 0 CEMBI HY Spread Historical low Source: J.P. Morgan, Bloomberg, EGCA, 31.12.2017 PERFORMANCE 2017 was marked by significant political uncertainty both in EM and DM coupled with the US rate hike cycle. Nevertheless, after only a brief sell-off following the US election results in November 2016, EM Corporate HY delivered an impressive return of approx. 10% in 2017. This comfortably outperformed US HY, which gained approx. 6%. We are optimistic for similar returns in 2018, though we are continually monitoring a number of risk factors, as outlined below. Source: JPM, Bloomberg, EGCA, 31.12.2017 POTENTIAL RISKS The greatest risk to EM issuers continues to be rapidly rising US/Europe rates. As in previous years, this risk should not lead to a significant market sell-off as the benign economic environment and improving credit metrics of EM corporates should be supportive. It is our base case scenario that potential central banks balance sheet reductions will most probably be implemented steadily and predictably to minimize market disruptions. This, coupled with a solid macro environment, should lead to positive returns from EM fixed income instruments in 2018. As you can see on the graph, historically, the CEMBI HY Index demonstrated positive performance during years of Federal Reserve rate hikes (2004-2007). Source: J.P. Morgan, Bloomberg, 31.12.2017
Overall EM growth 4.5% in 2018 and nearly 5% in 2019-20. Growth in commodity importers to average 6% in 2018-20. According to World Bank s latest outlook, growth in EMs accelerated to over 4 percent in 2017, due to enhanced industrial activity in commodity exporters and continued growth in commodity importers. Most EM economies benefited from a recovery in exports. Key economies such as Brazil and Russia emerged from recession, and the prices of most commodities driving EMs rose. This is in contrast to advanced economies where we believe the growth will subside, as labor market slack diminishes and monetary policy accommodation continues to unwind. This trend is aided by aging populations and weak productivity prospects. We believe that the growth in EMs will pick up, reaching 4.5 percent in 2018 and nearly 5 percent in 2019-20. This positive trend reflects a further acceleration by commodity exporters, as oil and other commodity prices stabilize and the effects of the earlier commodity price fluctuations dissipate. According to World Bank latest outlook growth in commodity importers is projected to remain stable, averaging nearly 6 percent in 2018-20. This forecast highlights the need for policymakers in both advanced economies and EMs to shift their focus toward boosting potential growth in the longer term. With unemployment rates returning to pre-crisis levels, productivity -enhancing measures become increasingly urgent as the pressures on growth from population aging in advanced economies and from technology disruption in EMs intensify. Among EMs, output gaps have been closed in commodity importers. Commodity exporters still have room to recover, suggesting a continued need to nurture the cyclical recovery.
Some 120 economies, accounting for three quarters of world GDP, have seen a pickup in growth in year-on-year terms in 2017, the broadest synchronized global growth upsurge since 2010. IMF, World Economic Outlook 2018 CHINA 1 RUSSIA BRAZIL Growth in China reached 6.8 percent in 2017 reflecting continued fiscal support and a strong recovery of exports. Domestic rebalancing continued, with drivers of activity shifting away from state-led investment. China s trade flows recovered markedly, reflecting rising commodity imports as well as strengthening foreign demand. Chinese growth will remain strong in 2018-20: around 6.5 percent. However, long-term drivers of potential growth point to a slowdown in China s growth over the next decade. as population aging is expected to retard productivity. After a two-year recession, the economy expanded by nearly 2 percent in 2017, bolstered by higher oil prices and supportive monetary policies. The decline in inflation from a 17 percent peak in early 2015 to below the 4 percent in 2017 steadied consumption growth. Stabilizing oil prices supported private investment, primarily in energy and transportation. Growth in 2018-2020 will be near 2 percent. A cyclical recovery is underway following a two-yearlong recession. Brazil s economy expanded by 1 percent in 2017. Retail trade and industrial production growth has picked up, despite a continued contraction in the construction sector. Labour market conditions are beginning to improve. Growth in 2018-2020 is expected to steady at 2.5 percent. INDIA SOUTH AFRICA TURKEY Growth slowed down to below 7 percent in 2017, partly reflecting adjustments by businesses to the prospective introduction of the Goods and Services Tax (GST). In addition, protracted balance sheet weaknesses - in particular, a corporate debt overhang and elevated non-performing loans in the banking sector - continued to weigh on already weak private investment. The manufacturing Purchasing Managers Index and industrial production growth temporarily weakened as producers reduced inventories amid uncertainty relating to the implementation of new tax policies. Growth will accelerate to 7.5 percent in 2018-2020. Strong private consumption and public spending on wage increases are expected to boost domestic demand. Infrastructure spending increases, with the goal to improve public services and internet connectivity. Increased economic activity in the agricultural sector, due to record rainfalls, helped South Africa exit recession in 2017. However, the mining and manufacturing sectors expanded at a slow pace amid policy uncertainty, which continued to weigh on business confidence. Growth will rise to over 1 percent in 2018 and nearly 2 percent in 2019-20. The parliament s review of the rules relating to the removal of President Zuma from office increases the uncertainty around this year s presidential elections, weakening South Africa s currency. MEXICO COLOMBIA GUATEMALA Growth in Mexico is forecasted to rise from above 2 percent in 2018 and to nearly 3 percent in 2019 and 2020. Investment will pick up, following reduced uncertainty in the renegotiation of NAFTA and the outcome of July 2018 presidential elections. Growth in Mexico in 2017 reached 2 percent, notwithstanding the effects of two powerful earthquakes in September. Economic activity was bolstered by private consumption, underpinned by a healthy labor market. The rise in remittances during 2017 was mostly related to the anticipation of possible changes in U.S. immigration policy, and will not be sustained in the future. 1 - World Bank Economic Outlook, 2018, EGCA as of 31.12.2017 Growth in Colombia is expected to pick up to 3 percent in 2018 and 3.5 percent in 2019-2020. The low inflation achieved by the central bank supports private consumption. Export growth is likely to recover on rising oil prices, while the continued implementation of the 4G infrastructure program further spurs growth. Policy uncertainty stemming from the forthcoming May 2018 presidential elections may slow down growth. Incumbent President Juan Manuel Santos is ineligible to run for office, because he has already served two consecutive presidential terms. The doubling in Turkey s growth to nearly 6 percent from 2.9 percent in 2016 was supported by fiscal stimulus after the 2016 failed coup attempt. Export growth rose on the back of strengthening demand from the European Union and competitiveness gains from the currency depreciation. Growth in 2018-2020 is expected to be normalized at around 4 percent. Guatemala s economic growth is expected to be steady at about 3.5 percent in 2018-2020. Domestic policy uncertainty continues to undermine business confidence and growth. An upside opportunity for growth is faster-than-expected growth of the U.S. economy.
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