The huge variety of emerging markets and the various speeds at which they are changing has presented rewarding opportunities for astute, active EMD managers. Rob Griffin reports.
Life in capital markets has never been the same since the devastating financial crisis swept the globe almost a decade ago, says Arif Joshi, who co-manages the Lazard Emerging Markets Bond fund with Denise Simon.
‘Anyone operating in global fixed income markets has had to determine what the unorthodox monetary policies will do to their asset class,’ he says. ‘On top of that we’ve also seen multiple rounds of quantitative easing in the US, Europe and Japan.’
However, this unique economic backdrop has also provided plenty of opportunities for those willing to do their homework.
‘It’s certainly been a fascinating period since the crisis and there have been a lot of winners in emerging markets,’ says Joshi. ‘This has made it a pretty ripe environment for active management within these markets.’
The challenge has been trying to find that all-important intersection between policies improving the overall economic prospects of a country and valuations still being compelling enough to provide a return that justifies the risk taken.
‘Countries such as Argentina have made significant strides,’ he says. ‘It’s gone from being a pariah nation to the point where capital markets are rewarding them for what they’ve done. A lot of that has had to do with simple political change.’
He cites President Mauricio Macri’s arrival in 2015 for ushering in an era of austere fiscal and monetary policy. ‘Argentina is now issuing a 100-year bond,’ he says. ‘If you had suggested a few years ago that would be happening, people would have laughed you out of the room.’
Such dramatic overhauls have also been seen elsewhere. In fact, Joshi says almost all of the large emerging market countries have witnessed political changes, ranging from looser overall fiscal and monetary policies, to more austere measures.
‘We like to visit government officials – as well as opposition figures – before major political events to get a sense of what the road map will look like for the first 100 days if they do win the election, as well as their vision for the first four to six years of their term,’ he says.
It’s a policy the team has already used to good effect. ‘We did it in Argentina prior to the 2015 elections, and in Ghana ahead of its elections in December 2016,’ he says. ‘We now have a very good sense of how successful those policy changes have been, which gives us more confidence in the positioning of these countries.’
Capitalising on recovery
Michael Gomez, the + rated head of Pimco’s emerging markets portfolio management team, says most of his returns have come from turnaround stories that had strong balance sheets but had been unduly punished by markets in the face of external and idiosyncratic shocks.
‘Having an anchor and understanding which balance sheets have the flexibility to successfully navigate these shocks has been a critical component to EM sovereign investing during the cycle,’ says Gomez, who ranks fourth over five years.
He highlights Russia as an example of a credit that was extremely tested by the market in 2014-15, under the double shock of sanctions and a collapsing oil price, but which has thrived due to a combination of a strong balance sheet and the policy response by the Central Bank.
‘It managed to produce one of the best risk-adjusted returns in external debt in the two subsequent years,’ says Gomez. ‘Likewise, Mexico and the Mexican peso came under heavy pressure following the Trump election, but that pressure faded.’
He attributes this to a combination of the US’ softening stance on Nafta and the fact the economy was anchored by an improving balance of payments and an orthodox policy response. ‘As a result, the Mexican peso has been the best-performing currency in EM this year,’ he says.
Gomez says there are several key inputs required for a successful strategy when it comes to emerging markets.
‘One is developing a well-defined top-down view of the risk factors affecting them, be it core-duration, the US dollar and commodities, among others. This is in part as a recognition that emerging markets can be subjected to shocks from these external influences,’ he says.
Then there is a bottom-up understanding of the investment universe, including a thorough analysis of the credits involved. ‘You also need a sense of the technicals in the market, including positioning and flows, to spot and assess potential market dislocations,’ he says.
Finally, it is important to be focused when it comes to valuations to ensure the fund is being adequately compensated for the risks. ‘Having a disciplined process that encapsulates these four inputs has served us very well over the years,’ he says.
AA-rated Luc D’Hooge (pictured), head of emerging market bond funds at Vontobel Asset Management, focuses on trying to find the best possible bonds from specific issuers. As a result, most of his returns have come from active bottom-up bond selection.
One example he highlights is Pemex, a Mexican state-owned petroleum company, where he chose the euro-denominated bond rather than the US dollar-denominated bond of a similar maturity.
‘By choosing the euro-denominated one, we were able to get around 80 basis points more of yield pick-up than the US dollar bond,’ he says. ‘This was after currency and interest rate risks had been hedged out,’ says D’Hooge, who is ranked fourth and second over three and five years respectively.
As far as current positioning is concerned, D’Hooge likes the carry that emerging market external debt still offers and remains overweight risk. ‘Latin America is still my favourite region as growth is returning from low levels,’ he says.
Elsewhere, Brazil and Argentina are coming out of recession, even though ratings agencies have been slow to upgrade the latter. His strongest bets, meanwhile, remain Mexico, Indonesia and Argentina.
‘For the first two, we reduced our exposure slightly,’ he says. ‘In Argentina, we increased exposure and started to invest a bit in the local market, looking for rate exposure, as we expect that the strong fall in inflation will lead to lower rates.’
D’Hooge takes advantage of anomalies in emerging markets because investors often overreact before calm returns. A prime example was the hysteria in China over fears of a sharp slowdown that have since receded.
‘Overreactions and mispricing in emerging markets are common and can be consistently exploited through an active investment approach,’ he says. ‘Investors brave enough to take contrarian views will be rewarded.’
It all depends on the opportunities available. ‘Sometimes there are some striking misvaluations and these opportunities are really a superior alpha generating source: low-risk trades with good upside,’ he says. ‘Bond selection is the most important aspect of our process and it’s where we differ most from other portfolio managers.’
These comments originally appeared in a supplement published with the July/August edition of Citywire Selector magazine.