By Satish Pulle, Lead Portfolio Manager at ECM Asset Management
The IMF’s October 2013 Financial Stability report has some comprehensive analysis of the market factors affecting emerging market debt. While there is not a great deal of new information, the data is useful to understand the drivers behind the current weakness and more importantly, to answer the question, is it over now?
Foreign portfolio flows into emerging market bonds have been above trend since 2009. The cumulative $900bn (net of valuation effects) that has found its way into EM bonds represents 4.7% of GDP, and is $370bn above the long term trend. When viewed at a more granular level, as a percentage of recipient country GDP, flows during 2009-12 have been more pronounced into Mexico, Poland, South Africa and Turkey. Notably, flows have been dominated by fixed income markets rather than equity markets. And therein lies the story.
Excessive fixed income flows always create a false sense of comfort – yields go down and credit quality looks better on the surface, as it is hard for bond vigilantes to argue against low credit spreads. For instance, Turkey was one of the larger recipients during 2009-12 with circa 2.5% of GDP flowing into bonds, driving local currency yield lower by about 2.75%. The rating agencies respond with upgrades – Turkey was upgraded to Baa3 Stable Outlook by Moody’s in May 2013, and to BBB- by Fitch in November 2012.
Yet, this excessive availability of debt finance sows the seeds of future vulnerability, as credit growth exceeds GDP growth, implying an increase in leverage. Real credit growth in excess of GDP growth during 2010-12 has been as high as 14% for Turkey, 12% for Brazil, and 8% for Russia. As domestic savings tend to be low in some emerging countries, this excess credit growth is funded by foreign lenders, and shows up as Current Account Deficits, which stand at a relatively high -7% for Turkey.
At some point, the excessive debt flows start to reverse. This time, the questions around flows started last May when the US Fed Chairman Bernanke announced that tapering their QE programme was being considered. Since then, outflows have begun though at relatively muted levels and spreads have begun to widen. And yet, as the attached graph from JP Morgan shows, 2013 was still a net positive year with $6bn inflows, though 2014 is starting off with small net outflows. If outflows pick up pace in the first half of 2014, as we expect, returns in EM fixed income are likely to be significantly negative.
At ECM, we have low exposure to emerging market sovereigns and credit. If there is a significant further sell-off and we then expect the tide to start turning positive again in the second half of 2014, we would consider adding some EM credit exposure.