For much of the second half of the year, developed market credit spreads saw measured widening from their trough during the summer. In contrast, emerging markets debt seemed fairly insulated from this trend, given already wide spreads.
However, the subsequent, extreme drop in crude oil prices triggered a deep correction in oil-related sovereign and corporate EMD credits. Now, a sell-off that started largely if not solely as a crude oil-related correction has morphed into a broad, EMD asset class-wide rout, affecting currencies and local rates.
One-sided impact
While we believe lower crude prices create both winners and losers, given the balance of oil-producing and oil-consuming countries across the emerging world, the short-term market effect of the declines has been one-sided, punishing producers but not yet benefitting oil-consuming countries in a symmetrical way.
Also, the positive effects on global economic growth, and ultimately on the demand for energy, provided by lower energy prices have not been reflected sufficiently, in our opinion, having been overwhelmed by negative sentiment associated with excess supply.
While it is impossible to predict where prices will ultimately find a bottom, we assume that, following such a large downward move, supply will begin to adjust lower as capital expenditures at oil companies are cut aggressively and as high-cost producers become unviable. This should especially be the case in the current situation, since the demand and supply imbalance was until recently not particularly large.
Deep value opportunities
The largely indiscriminate sell-off of the last few days, concentrated in areas where investor positioning is heavy, has now created what we consider deep value opportunities in many markets across EMD.
In the currency space, the Turkish lira and the South African rand, for example, have depreciated by around 6% versus the U.S. dollar since the end of November, even though both economies are experiencing a positive terms-of-trade adjustment on the back of the oil shock.
In local bonds, Brazilian rates have spiked about 50 basis points to 12.5% this month, in spite of weak growth dynamics and lower domestic inflationary pressures. In hard currency sovereigns, while the pain has been acute for oil-producing sovereigns, overall benchmark spreads have widened out by over 90 basis points so far in December to 410 bps, which easily surpasses the prior 2014 high of 360 bps in January, and brings us back to levels last seen in the summer of 2012 in the midst of the eurozone’s sovereign debt crisis.
While oil-dependent countries such as Russia and Venezuela have been severely affected, spreads on Russian sovereign debt have now more than tripled this year to over 700 bps and Venezuelan bond prices have collapsed by a third in December alone. In our view, notwithstanding the negative macro and geopolitical dynamics faced by Russia, such yields appear excessive for a sovereign that continues to have a very large external balance sheet buffer due to a low debt levels and extensive international reserves.
In the case of Venezuela, bond levels appear to have reached what we consider recovery values, essentially pricing in a default scenario, even though the country arguably faces liquidity issues but not (as of yet) insolvency given its available policy options.
Among corporate credits, the sell-off has been more contained than in the sovereign space. Asia makes up a larger portion of corporates, and the region has outperformed on account of its position as a net importer of commodities (with relatively small oil and gas, and metal and mining sectors).
However, various non-commodity sectors, such as telecommunications, have fared poorly. One concern regarding corporate credits is tied to its higher leverage and relatively large refinancing needs in external markets; a combination of lower commodity prices and lower local currency exchange rates could create refunding vulnerabilities in certain sectors if markets remain dislocated for an extended period.
Outlook for 2015 remains constructive
We continue to expect the global economic recovery to continue after a weak phase for the eurozone and Japan heading into 2015. In our view, the investment environment for EMD should be constructive next year given that monetary stimulus from both the European Central Bank and the Bank of Japan is likely to keep core rates at or near historical lows.
Upward interest rate movement in the United States is also likely to be contained given mounting global disinflationary pressures. Lower rates for longer could well be a theme that reinforces investors’ “search for yield” and supports the asset class.
Macroeconomic conditions have shifted and become more challenging for a number of EM countries, but most continue to have fiscal and external account buffers to count on, which allows them to deploy pro-cyclical policies, including tightening monetary conditions, as a way to smooth large currency moves, as occurred recently in Russia – floating currencies can act as escape valves and allow the process of rebalancing on the back of external shocks.
Also, we continue to believe that a slowdown in domestic consumption, especially acute in commodity producing countries due to needed fiscal consolidation in the near term, will be gradually offset by growing exports into the developed world as those economies recover. Nonetheless, we anticipate EM growth and export performance to remain subdued relative to previous recovery cycles.
Looking past current volatility
Our takeaway is that, while we have witnessed fundamental shifts in the markets, the sell-off has been extensive – and in some cases excessive – and most likely has been exacerbated by year-end market illiquidity. As a result, we are now seeing pricing dislocations in certain parts of the market, and what we consider compelling valuations have begun to emerge.
This does not protect the markets from more rounds of weakness, as fund outflows can trigger more forced selling, but beyond the immediate horizon the recovery prospects look enticing.