Interview
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SATURDAY, NOVEMBER 17, 2012
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A Debt World Turned Upside-Down
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By LAWRENCE C. STRAUSS
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Emerging-market bonds, once a minefield for investors, have produced big returns recently, and the outlook remains good for many of the issuers.
In recent years, as the U.S., Western Europe, and other parts of the developing world have struggled financially, the emerging markets have been held out as a compelling alternative for investors. However, there are big disparities between their stock and bond markets. The JPMorgan EMBIG Global Core Index, which tracks sovereign debt in developing lands, has generated three-year annual total returns of 12.36%, versus 5.63% for the MSCI Emerging Markets Index, which tracks equities.
What's next? For insights into the outlook for emerging-market debt, Barron's spoke recently with Joyce Chang, managing director and head of emerging markets and global credit research at JPMorgan. Chang, who travels widely for her research, sees more upside in many developing lands, thanks to strong economic fundamentals.
In 23 years of covering emerging markets, the 47-year-old Chang has watched countries such as Brazil improve their fundamentals, thanks partly to its accumulation of vast sums of foreign-exchange reserves, which now total about $370 billion. We interviewed the veteran analyst in her New York office.
Barron's: Let's start with your macro view.
Chang: The financial crisis in the developed markets has led to a rerating of emerging markets' debt. In 2007, countries that accounted for 50% of GDP [gross domestic product] in the developed markets had an AAA rating, but now it is less than 20%. And in that period, you've seen emerging countries achieve investment-grade ratings across debt issued in local markets, corporates, and sovereign debt.
From the end of 2007 to the end of 2011, the developed countries averaged an increase in public sector debt-to-GDP ratio of about 36.5 percentage points. At the peak, the average developed country had a public debt-to-GDP ratio of 114%. In contrast, for emerging markets at the end of 2007, the figure was 36%; it is 34% now.
Emerging markets have already worked through a lot of their issues and crises, mostly during the 1990s. Since then, they have achieved investment-grade status, but emerging-market debt is also growing as an asset class. Since the end of 2008, the market cap of the emerging-market fixed-income indexes, in aggregate, has doubled, to $2.5 trillion. In September, emerging-market corporate bonds crossed the $1 trillion threshold -- that market is now the same size as the U.S. high-yield market.
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And there is an economic-growth story. Our forecast calls for only 1.2% GDP growth this year in developed markets and barely any more than that next year.
Currently, more than 70% of global growth is coming from emerging markets, even with China slowing down and Brazil having a very disappointing year.
What concerns you about the emerging markets?
The biggest risks come from the developed markets' outlook, since many of these countries export to them. There is no such thing as emerging markets decoupling from the developed ones. We estimate that every 1% slowdown in GDP growth in developed economies equates to about a 0.9% slowdown in emerging markets' growth.
Emerging markets' growth, at 4.7%, will be four times that of developed markets this year, but it is still below its potential. In fact, it is actually the lowest they have recorded, other than at the height of the financial crisis, over the past decade.
How concerned are you about spillover from the financial crisis in Europe?
An interesting question. Kazakhstan and Italy have the same credit rating now. Russia is actually rated one notch higher than Italy. India, Spain, and Indonesia all have the same credit rating. So, the world really has rerated. But the spillover has been a lot less than what one would have thought. A year ago, everybody was worried about European bank deleveraging and what that would mean for emerging markets. That was particularly true for Spanish banks: What would that mean for Latin America? But the emerging nations have developed their own local debt markets -- and their own local investor base -- and that really hasn't been a big stress point.
What's driven the improvement in fundamentals in many of the developing lands?
In emerging markets, almost every crisis got rid of one of the sources of that particular crisis. For example, when you look at the sources of the emerging-markets crises of the late 1980s and early 1990s, it was often about a country trying to sustain a fixed exchange rate and blowing through its foreign-exchange reserves. So, they moved to floating exchange rates. Also, a lot of countries that are commodity exporters accumulated foreign-exchange reserves, and adopted fiscal rules that said they had to save the windfall. They adopted inflation-targeting regimes, too, because they had a history of hyperinflation; one example is Brazil.
So some of this was luck for emerging markets. More than two-thirds of them are some form of commodity exporter -- not just oil, but agricultural commodities, metals, etc. Right now, there is $10 trillion of global FX [foreign-exchange] reserves, with $8 trillion of it in emerging markets. It is not just a China story. Latin America, which had a series of severe debt crises in the 1980s and 1990s, has about $760 billion of FX reserves, and its total public-sector debt is $350 billion. So Latin America is a net external creditor. Russia has $500 billion of reserves. Brazil's reserves total about $370 billion.
When I first started covering them in early 1990s, these countries' reserves covered maybe one or two months of imports. Now, about two-thirds of the emerging-market countries in our index are net external creditors.
Equity markets such as those in Brazil and China have had mixed performance in recent years, though it's been better recently. Why have debt securities outperformed stocks in developing markets?
Emerging-market debt is very different from emerging-market equities. The equity story is much more of a BRIC [Brazil, Russia, India, China] story.
If you look at the local-currency debt index for emerging markets, neither China nor India is included because they aren't investable for foreigners. Part of the reason debt has done better than equities is that while the China story is very important to the macro outlook, it is not a very big part of the debt indexes themselves. China is not a huge debtor country. The strength of the balance sheets of many of these countries simply isn't being taken into account in the equity markets so far.
What about inflation?
The biggest surprise this year, actually, was that inflationary pressures have been much lower than anyone had expected in July of last year, when inflation in China hit 6½%. Everybody was really worried back then that inflation was going to be more of a problem. But inflation has actually moderated; we are probably at bottom right now. In Latin America, there are inflationary pressures. But frankly, given where we are in the growth cycle, inflation has just not been the biggest concern.
What are some of your key geopolitical themes for these markets?
Over the past few years, the politics in Europe has become as worrisome as some of the politics in emerging markets. So we always watch this very closely. But if you look at the elections this year -- in Mexico, for example -- they went very smoothly and there was a very smooth transition. That used to be a huge source of volatility when I first started covering emerging markets. Even Venezuela, where we have an overweight recommendation, [President Hugo] Chavez won the elections in what actually seemed like a relatively fair process; the opposition candidate made a strong showing.
So the pure political risk related to elections in emerging markets is probably quite a bit less than it was 10 to 15 years ago. Elsewhere, there is geopolitical risk related to Iran, which has hit the commodity markets.
Emerging markets are affected by that, both negatively and positively. But I don't know if that's a risk specific to emerging markets; it seems to be more of a global geopolitical risk.
What other geopolitical issues are you paying attention to?
Last month, I attended the annual meetings of the IMF [International Monetary Fund] and the World Bank in Tokyo. A lot of the discussion was about the decision by the Chinese leaders to cancel going to those meetings. The IMF-World Bank gathering isn't seen as a Japanese-specific event, [so the current tensions between China and Japan over territorial issues shouldn't have been a big factor in the decision]. That they canceled going to a major global forum raised questions about what it means for the political transition in China. What is the leadership about? What are their priorities? All of that is a factor in emerging markets.
Just how well has emerging-market debt performed against other investments?
Since the Lehman Brothers crisis in September of 2008, emerging-market debt has delivered total returns of 60.4%, versus 8.3% for U.S. equities. U.S. high-grade bonds have had a total return of 2.2%, compared with 0.7% for U.S. high-yield bonds. Emerging-market equities have been much more volatile, up 14.6%. So, on a risk-adjusted basis, emerging-market debt has probably had one of the highest returns since the onset of the global financial crisis.
What's driving that -- and what will continue to drive that -- is supply and demand. Taking into account all U.S.-dollar credit products, which includes U.S. high-yield and high-grade debt, as well as emerging- market corporates, sovereigns and structured products, there was a massive drop in supply after the financial crisis.
Issuance of structured products stopped, and total credit-product issuance went from $1.5 trillion annually to less than $400 billion; that's come down even further this year. The supply-demand imbalance is a major reason for the outperformance.
Is the outperformance continuing?
We had a year-end yield target for the EMBIG, which tracks sovereign debt in the emerging markets, at 250 basis points [2.5 percentage points] above U.S. Treasuries. We're pretty much at that target now. The index that tracks corporates trades about 50 basis points wider than that. And then for the index that tracks debt issued in local markets, the spread is about four percentage points. It has a single-A rating.
So you have better fundamentals in many of these markets, and investors can get big yield spreads over Treasuries. But why doesn't that spread come in further?
Because rates still remain very high in emerging markets. The average rate in emerging-market countries is 5.8%. They have much higher rates, compared with those in the developed markets.
One thing we should point out is that, for individuals, there are relatively few plays on these markets, short of buying bonds directly, which can be complicated. BlackRock's iShares offers the USD Emerging Markets Bond Fund (ticker: EMB), which tracks sovereign debt, and the iShares Emerging Markets Corporate Bond Fund (CEMB). And Fidelity has the actively managed Fidelity New Markets Income Fund (FNMIX), but there's not a lot out there. In any case, in what countries do you see the best opportunities for investors?
After this rally in emerging-market debt, the sovereign debt of Mexico and Brazil yields less than 100 basis points [or one percentage point] above U.S. Treasuries. But the average EMBIG spread is around 250 basis points, so countries like Mexico and Brazil aren't very attractive; they're not getting you much of a pickup in yield.
Instead, we like some higher-yielding names. For example, we are overweight Venezuela. Its sovereign debt yields about 900 basis points [nine percentage points] over Treasuries. Venezuelan sovereign debt is up about 30.8% year to date.
Also, some of the Middle Eastern names that have a high level of state support are attractive, like the Dubai holdings: Aldar, a real estate and investment company in Abu Dhabi, and EMAAR, which is developing the Dubai marina. These are quasi-sovereign credits. We can see that, too, in the oil-and-gas sector in Russia, with companies such as Gazprom (GAZP.Russia) and Lukoil (LKOH.Russia).
Thanks, Joyce.
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