EM Sovereign Debt 2014: Neither Phoenix nor Failure
Emerging-market (EM) sovereign bonds were burned badly in 2013. Will they rise from the ashes in 2014? We believe some will and some won’t. The watchword for 2014 will be selectivity.
While the sector is unlikely to deliver double-digit returns this year, last year’s sell-off created opportunities, and successful investing can take advantage of these dislocations.
We tend to segment EM countries into three groups: Low Risk, the “Fragile Five” and High Risk. Members of each group share some risk/return characteristics, but specific country-by-country risks create the potential for diverse return experiences. Within each group, selectivity will play a big part (see Display).
Low Risk. In this group we include countries such as Mexico, Chile, Poland and the Philippines. All of these countries have strong credit metrics and good macroeconomic policies. Let’s look at two examples: Mexico and the Philippines.
In Mexico, the US recovery should lift external demand. Expansionary fiscal policy should spark domestic demand, and President Enrique Peña Nieto’s reform agenda should help growth. The Philippines has ridden a strong growth wave (gross domestic product in excess of 7%) that has led to credit-rating upgrades. Growth should cool off slightly this year—and so should the country’s upward rating momentum. There are also concerns about reductions in the inflation target of the Central Bank of the Philippines and what that could mean for monetary policy.
We have positive views on both economies, but Mexican debt is trading at a yield spread that’s 45 basis points (bps) wider. Given the strong outlook, it seems a better value.
The Fragile Five. In 2013, the market questioned the ability of some countries to finance their external debt, with particular scrutiny of Brazil, India, Indonesia, South Africa and Turkey. These five countries make up nearly 25% of the JP Morgan EMBI Global index, with a weighted average return of –11% in 2013. While the near-term prospects for these countries may be challenged, we’re confident about the medium-term outlook for most of them.
If we compare South Africa and Indonesia, we see that both countries have busy election calendars in 2014 that will dominate headlines but should go relatively smoothly. Both countries’ current accounts are likely to suffer from weaker demand from China. However, Indonesia’s government is expected to focus on managing its current account balance, while South Africa’s larger external-financing needs place it at risk if portfolio inflows dry up.
Inflation was a problem for both countries in 2013, but Indonesia’s 2014 inflation forecast is below 5% while South Africa’s is above 6%. We haven’t liked the policy mix in South Africa and believe that it’s a deteriorating credit. Our views on Indonesia are the direct opposite: it has a high domestic savings rate and has made a much bigger investment in infrastructure. In addition, Indonesia offers a more appealing yield spread—45 bps higher than that of South Africa.
High Risk. There are interesting gradations to the challenges among high-risk countries, too, and investors should look carefully at which risks are worth taking. This group includes about a dozen countries, among them Argentina, Belarus, Pakistan, Ukraine and Venezuela. These five share very poor macroeconomics and uncertain political situations. In aggregate, we remain cautious with this “high-risk” group; we believe political change is needed in each before real economic reforms can be implemented. We think the best opportunity for such political change exists in Argentina, which makes this country’s sovereign debt more appealing than those of the other four.
Looking Beyond the Benchmark
The evolution of EM debt should lead investors to view the asset class much like they do developed-market credit: scrutiny of relative value and market dislocations is key to uncovering opportunities. In our view, a blanket allocation to benchmarked strategies misses the mark.
This is illustrated by the experience of high-yield EM sovereign debt in 2013, when there were tremendous success stories, with Belize returning +49% and Argentina +19%. But Venezuela turned in a depressing –12%, and it accounts for more than one-fifth of the JP Morgan EMBI Global High Yield Index, which was down 4% overall for the year. We believe the best way to take advantage of dislocations within EM sovereign debt is to move away from the benchmark.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Paul DeNoon is Director of Emerging-Market Debt at AllianceBernstein.