Market sentiment towards emerging market (“EM”) credit can be broadly split into two categories – structural and tactical views.
This year started with market participants focusing very much on a tactical view – the outcome of the US-China trade relationship.
Initially, the term used to describe this relationship was “trade war”, which turned into “trade truce” as the relationship between the two countries thawed, and then “trade talks” amid signs of progress towards a deal and now seemingly full circle back to “trade war” as the tit-for-tat heats up again.
Given how much the rhetoric can change week to week, we believe in a prudent approach to help our portfolios be resilient to trade headlines, rather than trying to take strong views on the trade issue itself.
An example of how markets can take a structural view, on the other hand, can be seen in the case of Turkey and Argentina. The weaknesses of these economies took years to build and strength, if any, will also take years to rebuild.
Our structural view on these two countries is that there are individual credits that offer good value, but macro risks will likely lead to some of the highest volatility among EM countries.
Turkey and Argentina, though, are exposed to volatility in very different ways, creating opportunities for the active manager.
For us, country differentiation and an agile investment style are keys to finding the best risk-adjusted returns within EM even during times of volatility, and these two countries illustrate our approach.
Nevertheless, we are continually asked whether Turkey and Argentina might spoil the EM rally this year, just as they did in 2018.
The renewed inflows into EM have been driven by a notably more dovish US Federal Reserve, which is keeping a lid on the dollar and leading to a managed slowdown in China, both of which have made valuations across emerging markets appear attractive again. Where do we stand?
Turkey: Defensively positioned with liquid hard-currency sovereign bonds
We have concerns over the long-term macro picture for Turkey. Turkey’s economic vulnerabilities are well-known – high inflation and a huge current account deficit – and they are the main reasons why the lira fell 40 percent against the US dollar in the first eight months of 2018.
Turkey’s chronic deficit points to its reliance on US dollar-denominated borrowing to fuel the domestic consumption boom under President Recep Tayyip Erdoğan, which came unstuck as the US called time on quantitative easing and started raising interest rates last year.
Turkey’s long-term structural risks – high inflation and large deficit – suggest that the country is still very much exposed to external shocks.
Compared to last year, Turkey’s liquidity has recovered, and the economy is benefiting from decent returns in the short-term. But the country is now much less fiscally disciplined than in the previous crises it managed to muddle through.
Turkey’s “black box” of unknown government spending is getting bigger and without any visibility on the total balance. There are reports, for example, of “stealth stimulus” in the form of government contingent liabilities and subsidized SME lending, while forbearance measures have been introduced to Turkish state banks but with no visibility for investors on the true level of non-performing loans (NPLs) in the banking sector.
For these reasons, we favor Turkish sovereign (and sovereign-linked) bonds, which are liquid and can be effectively hedged through credit default swaps (CDS).
We are less keen on Turkish corporate debt; corporate valuations seem high given the recent rally and we would rather err on the side of caution given that Turkey’s black box of unknown spending is unlikely to be positive news for risk assets.
This conservative approach to holding liquid sovereign debt means that we can benefit from rallies within Turkey, but we are close enough to the “exit door” in case volatility strikes.
Argentina: Opportunistically positioned with corporate bonds
In contrast to the long-term risks we see in Turkey, we are more conscious of idiosyncratic, medium-term political risks in Argentina.
The first round of the presidential elections takes place in October and investors are highly sensitive to a political shift away from President Mauricio Macri to former left-wing president Cristina Fernández de Kirchner, who it is rumored may announce a re-run. Markets fear a binary choice between the continuation of Macri’s market-friendly policies or the return of default risk.
Polls are currently neck-and-neck between the two. For Macri to be re-elected, Argentina needs to see improving economic data. Argentinian GDP growth fell 2.5 percent in 2018 and ended the year with the second-highest inflation figure in Latin America at 47.6 percent, behind only Venezuela, forcing Macri to seek a US$56 billion bailout loan from the International Monetary Fund and announce unpopular austerity measures.
All this, and an untimely drought, sparked a severe currency crisis, with the peso losing more than half of its value against the US dollar.
The austerity measures also pushed the Argentinian economy into recession yet at the same time boosted investor confidence on the expectation they would lay the foundation for a sustainable recovery.
And it did to some extent. Agricultural production rose 4 percent year-over-year in the last three months of 2018, a sector which is responsible for 10 percent of the country’s GDP, but four months into 2019, overall economic recovery remains weak.
Inflation was 2.9 percent month-on-month in January which missed the market’s expectation of 2 percent, triggering a sell-off in Argentinian assets. The second quarter however may improve following crop data releases that are expected to be strong.
In addition, Argentina’s current account deficit is expected to narrow significantly, as the weaker peso combined with declining consumption and investment may cause exports to rebound and imports to contract.
Capital inflows, meanwhile, are likely to remain weak given the election uncertainty. For active investors like us, this means we are still finding good corporate bond opportunities which offer attractive carry at lower valuations versus the broader index.
Given idiosyncratic risks, we expect sovereign bonds to be vulnerable to currency volatility, so we are not exposed to local currency.
In contrast to our position in Turkey, therefore, we believe corporate bonds are better positioned to withstand volatility in Argentina. We prefer defensive companies such as utilities and airports.
We maintain a nimble approach to managing exposure – we were overweight Argentina versus the broader index for most of 2018 and are now tactically in line with the index given the scope for better opportunities that may be thrown up by further volatility.
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