Investment Stewardship Guidance InvestmentPerspectives August 2016 Strategy Update: Emerging Markets Debt BEN MOHR, CFA, SENIOR RESEARCH ANALYST, FIXED INCOME Given the heightened volatility in financial markets over the past year from the shale crisis to Brexit, investors are rightly concerned about emerging markets debt ( EMD ) allocations. This strategy update examines key fundamentals of emerging markets debt and identifies reasons to retain this asset class in portfolios. Introduction: Favorable Opportunity Set In mid-february, markets shifted course from risk-off to risk-on, as oil prices reversed their descent, the high yield market stabilized, and the Fed held off on additional rate increases. Since then, equities have risen and many fixed income strategies including EMD have delivered solid returns year-to-date. 1 Critically, though, EMD continues to offer significant upside potential, even after the first seven months worth of return in 2016. The opportunity set within emerging markets debt is favorable; Exhibit 1 below shows key fundamentals of select emerging markets countries, with government bond yields for Brazil as high as 14.3% and Russia at 9.3%. This is in contrast with the U.S., where 10-year Treasury yields currently trade around 1.50%, with German and Japanese yields in negative territory. The total leverage column shows emerging countries with better debt profiles than their developed counterparts. Finally, yield per unit of leverage shows emerging countries with more value versus their developed counterparts as well. For example, Indonesia s ratio is 11.6 times versus Germany s at 0.0 times. Exhibit 1: Yields of 7% to 14% in Low-Levered Emerging Markets Sovereigns Country 10 Yr Yield (%) 2016E GDP Growth (%) 2016E Inflation (%) Total Lev. (Debt/GDP, %) Yield per unit Lev. Key Emerging Markets Countries Indonesia 7.6 5.1 5.4 65 11.6x Brazil 14.3-3.5 6.3 143 10.0x Russia 9.3-1.0 8.6 93 10.0x Turkey 9.7 2.9 7.0 108 8.9x Mexico 5.9 2.6 3.0 71 8.3x S. Africa 9.3 0.7 5.9 127 7.3x India 7.5 7.5 5.5 126 5.9x Poland 2.9 3.5 1.0 133 2.2x China 2.9 6.3 1.8 240 1.2x S. Korea 1.8 3.2 1.8 231 0.8x Average 7.1 2.7 4.6 134 6.6x Key Developed Markets Countries U.S. 1.5 2.4 0.8 367 0.0x Germany -0.2 1.5 1.2 278 0.0x Japan -0.3 0.5 0.3 538 0.0x Note: Debt/GDP defined as government, household and business debt divided by GDP Source: Bloomberg, IMF, U.S. Treasury, Federal Reserve, Eurostat, Ministry of Finance Japan, OECD, Bank of International Settlement; most recent available data. 1 Emerging Markets Debt, as measured by the JPMorgan EMBI Global Diversified hard currency sovereigns index, is up 12.3% year-to-date through July 31, 2016. 180 North LaSalle Street, Suite 3500, Chicago, Illinois 60601 PHONE 312-527-5500 CHICAGO BALTIMORE ST. LOUIS WEB marquetteassociates.com
Returns & Index Values: Attractive Shown below in Exhibit 2, the emerging markets debt hard currency sovereign index has returned 12.5% through the recent credit rally from its early 2016 lows, nearly as high as U.S. high yield with a 13.9% return. However, emerging markets local currency sovereign debt and emerging markets corporate debt have not yet enjoyed as high a surge, with only 7.6% and 9.9% returns, respectively, throughout this period. High yield has benefited significantly from the stabilization in oil prices since the shale crisis; EMD, however, was not hurt as much by the drop in oil during the shale crisis and thus has not enjoyed as large a rebound as high yield. Exhibit 2: Return Since Recent Correction Since Shale Crisis (1/31/16-7/31/16) Emerging Markets Debt Hard Currency Sovereign (JPM EMBI GD) 12.5% Emerging Markets Debt Local Currency Sovereign (JPM GBI-EM GD) 7.6% Emerging Markets Debt Corporate (JPM CEMBI BD) 9.9% U.S. Bank Loan (CS LLI) 6.5% U.S. High Yield (CS HY) 13.9% Over the long term, blended emerging markets debt has outperformed a blended strategy of U.S. bank loans and high yield. This was especially true in both the housing and shale crises. Exhibit 3 below shows the index values, beginning with June 2006 as a uniform starting point, for the EMD indices and the bank loan and high yield indices. The EMD local currency sovereign index showed tremendous resilience throughout the 2008 U.S. housing crisis, with a far less pronounced dip compared to all of the other indices shown. Likewise, both the EMD local currency sovereign and hard currency sovereign indices were more resilient than the high yield index through the recent 4Q15/1Q16 U.S. shale crisis. If nothing else, these graphs show the diversification benefits of an EMD allocation versus high yield and bank loans, especially during times of stress in the U.S. financial markets. Exhibit 3: Index Values Strategy Update: Emerging Markets Debt August 2016 2
Spreads: Therein Lies the Opportunity As a result of the spread-widening in the credit sector until mid-february, emerging markets debt has become attractive. Exhibit 4 below shows spreads of the emerging markets debt hard currency sovereign index in the blue, the EMD local currency sovereign index in the red, and the EMD corporate index in the black, all three of which are tighter than U.S. bank loans in the orange and U.S. high yield in the light blue. However, the EMD indices include China and Korea, whose spreads are tight, whereas other countries like Brazil and Indonesia feature wide spreads. In the next exhibit, we examine a few of these countries and sectors to identify some of the more compelling opportunities. Exhibit 4: Spreads Exhibit 5, on the following page, shows the Brazilian local sovereign spreads in blue, which are comparable to U.S. high yield energy spreads, the widest of U.S. high yield. It also shows Indonesian local sovereigns in red, which are wider than U.S. high yield food spreads, the tightest of U.S. high yield. Exhibits 4 and 5 underscore the importance of active management in the EMD space. Clearly, the spreads of each index suggest that high yield and bank loans are more attractive than EMD. However, when we scrutinize the individual country constituents of the EMD opportunity set, it is clear that significant value and upside potential exist and successful active managers should be able to translate these opportunities into profits for investors. Strategy Update: Emerging Markets Debt August 2016 3
Exhibit 5: Spreads by Country/Industry Conclusion: Maintain Strategic Allocations to Emerging Markets Debt Marquette recommends that investors maintain their strategic, long-term allocations to a blended emerging markets debt strategy. Post-Brexit, emerging markets debt has been up as a result of better competitive dynamics between emerging markets countries versus Europe. In addition, emerging markets debt may have been oversold leading up to Brexit. Furthermore, the markets are slightly more risk-on, now that oil prices have stabilized, and volatility from the two-year Brexit negotiations will introduce opportunities within the asset class. Overall, the global credit outlook can be summarized as reasonable in fundamentals. We are constructive in this space and believe there could be further spread tightening. We expect slow, moderate global economic growth, which is accretive for credit. However, volatility is expected to remain elevated. We expect default rates to be low outside of energy and metals and mining. High yield and bank loans right now are fairly valued, and not as cheap as mid-february anymore, while EMD spreads are still wider than long-term averages. The maturity wall for EMD, bank loans and high yield remains modest. There is very little debt due in the next few years, and we have not seen aggressive relevering. On the technical side, new issuance has been very low versus the same time last year, but has recently increased. Flows into high yield have also risen. We are seeing outflows out of bank loans because investors are anticipating the next rate hike further down the road. EMD issuance has also slowed the last few quarters, a sign of reduced frothiness from the peaks a year ago. The attractive valuations in the form of wide spreads, coupled with lower leverage of EM issuers versus developed markets issuers and a better competitive position now versus the EU post-brexit, make emerging markets debt attractive. Certainly, currency movements are a source of risk that always bear monitoring, but overall EMD remains a good long term hold for a diversified portfolio. We recommend a blended strategy executed by active management, with the goal of providing additional yield to fixed income portfolios while diversifying away some U.S.-based interest rate risk. Strategy Update: Emerging Markets Debt August 2016 4
PREPARED BY MARQUETTE ASSOCIATES 180 North LaSalle St, Ste 3500, Chicago, Illinois 60601 PHONE 312-527-5500 CHICAGO I BALTIMORE I ST. LOUIS WEB marquetteassociates.com The sources of information used in this report are believed to be reliable. Marquette Associates, Inc. has not independently verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on financial market trends constitute our judgment and are subject to change without notice. References to specific securities are for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results. About Marquette Associates Marquette Associates is an independent investment consulting firm that guides institutional investment programs with a focused three-point approach and careful research. Marquette has served a single mission since 1986 enable institutions to become more effective investment stewards. Marquette is a completely independent and 100% employee-owned consultancy founded with the sole purpose of advising institutions. For more information, please visit www.marquetteassociates.com. Strategy Update: Emerging Markets Debt August 2016 5