GLG Emerging Markets Debt Strategy
Q3 2017 Performance update
ZACK WROOT: Hello, my name is Zack Wroot, and I’d like to welcome you to the GLG Emerging Markets Debt Strategy live web conference call with my colleague Guillermo Ossés. Today, Guillermo will give an update on the strategy and share his thoughts on the past quarter. I would now like to hand you over to Guillermo; Guillermo, over to you.
GUILLERMO OSSÉS: Thank you Zack. Over the next few minutes I’m going to discuss the reasons behind the defensive positioning that we have had over the last few months, and where we think the opportunities are. And we’re going to cover valuation and position in the currency and credit markets with in EM, and the factors that we think are going to drive potentially to a correction from which we plan to take advantage, to try to buy assets at better levels from where we are now.
So let me go to slide 5 of the presentation. I wanted to start here, where in the grey line in the graph that you see in front of you, you will see the evolution of the valuation of the currencies that are part of emerging markets local bond index relative to the US dollar, adjusting by the inflation differential. And the onus here is that emerging market currencies I mean appear to still be relatively cheap versus the US dollar. In addition to that, if you look at the blue line in the graph, you can also notice that the current account balance as a share of GP for the countries that are part of the emerging markets local bond index have successfully corrected between 2013 and now, and are back at the balance levels that we had in the mid-2000s, which preceded a number of periods with good performance.
Now, over the next few minutes, I’m going to explain why we think that we will still have to potentially see additional adjustment in emerging market currencies to weaker levels, which will make possible further improvement in the current account balance, which will be required to meet the capital outflows that we think are going to take place as a consequence of the tightening monetary policies by developed market economies and in particular the Fed and the ECB. Now, the silver lining here is that once this adjustment is done, emerging market currencies will be in strong position to take advantage of the next few years.
Now, before we get there, we’re still going to go through some volatility, and if you let me take you to slide 7 of the presentation, here you get a sense for how crowded long position in emerging market currencies are today currently. The white line that you see in the graph on page 7 shows positioning of the Chicago Mercantile Exchange on a basket of five currencies, where this basket has a very high correlation with the performance of the emerging market local currency index.
The positioning on this basket is representative in the first axis on the right side of the graph. And you can see that at 347,000 contracts long currencies short dollars, speculative long currency position right now is close to the all-time highs. In the last 15 years, the only three other occasions when speculators have been this short dollars long currencies was in early 2013, right before tapering; in July of 2011, which was followed by two months of significant correction in emerging market currencies; and in mid to late 2007, which was followed by the global financial crisis. We do believe that over the next few months speculators are going to have to get out of these long currency positions, and this will trigger a correction.
If you look at the blue line on this graph, which shows the cumulative performance for the emerging markets local bond index, you can clearly see here that speculators were short currencies between February 2016 and June 2017, and during that period the emerging markets local bond index, represented by the blue line, returned close to 20%. Now, between June and now, speculators have gone materially long currencies, pretty much at the top of the market. And it’s very difficult for us to believe that this group of investors, who were wrong for a year-and-a-half on the short currency side, are going to have the stomach to maintain these very aggressive long currency positions at current valuations, given what I’m going to describe in a few slides from here when we discuss monetary policy.
On the credit side of the asset class, if you allow me to take you to slide 8 of the presentation, you see a representation of how new issuance has evolved. On the graph on the left side of page 8, you can see that 2016 was a record year of new issuance, with a bit more than $400bn issued by emerging market insurance and corporates for the whole year.
Now, if you look at the right side of slide 8, you can see that so far in 2017 emerging market issuers have sold new debt by an amount that is 20 to 25% larger than what it was the case back in 2016 for the same period of the year. The quality of this issuance has substantially deteriorated with high yield and new issuance being more than 80% larger than what it was the case in 2016. And here it’s important to take into account the fact that the average emerging market hard currency investor has very large allocations to emerging market corporates. We estimate that so far in 2017 there’s been more than $300bn worth of issuance by emerging market corporates. But in the secondary market out of 646 emerging market issuers that we track, there’s only 14 that trade more than $10m a day. So imagine the amount of adjustment in prices that would be necessary if just a portion of the amount of corporate paper that was issued so far in 2017 had to be liquidated. And this is one of the reasons why we’re so cautious on the prospects for hard currency credit.
If we now go to slide 10, you see here a graph on top of the page that shows the evolution for spreads over treasuries on the high yield component of the MB Global Sovereign Bond Index. And you can see here that once you stripe out the Venezuelan component of the benchmark, emerging markets high yield sovereign bonds are trading at spreads that are as tight as where we had right before tapering. Just out of curiosity the investment grade component of the MB Global Index today is trading between 70 and 100 basis points wide to the all-time lows, which we saw back in 2007 right before the global financial crisis – which clearly doesn’t provide much cushion in the event that we had a correction in treasury yields or in bond yields.
Now, moving on to page 12 of the presentation, you can see on these tables the composition of the MB Global Sovereign Bond Index. If you focus on the tables on the left and upper right side of this page, which contain the countries that we believe are likely to continue to service their foreign debt without extraordinary stress over the next five years, you can see that out of the 313 basis points of spread over Libor provided by the index as a whole, only 191 basis points are generated by the 89% of market value represented by the countries that we think are likely to pay back their debt over the next five years without much stress. So the yield that investors see in their external debt portfolios, which in the past they have assumed would convert into annualised return if they held onto the positions for long enough, it’s actually not likely to materialise in return when you take into account the risk of default from roughly 10% of the market value of the index that includes the weaker credits.
Now, as you’re probably aware, we have had these valuation levels and crowding of positioning pretty much since the beginning of the second quarter of this year. And the question that many investors pose to us is what is going to change the situation? And in that regard we think that the game changer here will likely be the steepening of the curves of US treasuries and bonds. And that will be triggered by market pricing of a normalisation in monetary policy.
Why is it that we think that we’re going to see such normalisation? If you go to page 13 of the presentation, in the graph shown on this slide, we see a blue line that shows the evolution of the unemployment rate in the US for the last years 60 or so. And some grey bars in different parts of the chart that indicate periods under which the US economy was in recession. What you can see in this graph is that in the last 60 years every time the US unemployment rate dipped through 4%, very soon after the US fell into recession as the Federal Reserve was forced to tighten monetary policy more aggressively than when the market had been expecting.
We believe that the market is incorrectly assuming that the Fed is going to be wrong in its interest rate projections over the next two years, just like it’s been the case between 2009 and now. But to us the big difference is what’s happening with under-employment, which is represented by the red line in this graph, which in the last few months has fallen quite quickly and is now at levels that are comparable to where we were prior to the previous recession during the global financial crisis. We essentially think that the US economy has run out of labour slack, and that this is going to start to generate inflationary pressures. The challenge that the Federal Reserve is facing right now is to some extent highlighted in slides 14 and 15.
In slide 14, you see a grey line that shows the level of financial conditions in the US economy, as measured by the Chicago Fed. When that grey line goes down it means that financial conditions are more expansive and vice versa. The blue line in the graph shows the evolution of the Fed past rate. What you can see here is that up until the mid-2000s whenever the Fed move short-term rates financial conditions are adjusted very quickly. In the mid-2000s, the Fed increased the Fed funds rate for almost three years between the end of 2004 and 2007. And financial conditions only finally adjusted in a very sharp way triggering the global financial crisis in 2008, a long time after the Fed has started tightening rates.
Back then, when it was known as the shadow banking system, was injecting liquid in the system, neutralising the tightening that the Fed was attempting to perform. You can see when you look at the right side of the graph that we’re in a similar situation today. The Fed has been tightening the Fed funds rate since December of 2015, and between then and now financial conditions have only expanded. We think that the main drivers of the financial conditions expansion that we’ve seen over the last year to two years have been the US treasury - and I’ll explain that in a minute - and the European Central Bank quantitative easing policies. Both of these factors are now going to cease to expand financial conditions. This is why we think that monetary policies was going to drive to the adjustment in EM asset prices.
Now, what does the Treasury have to do in all of this? If you go to slide 15, you see here a graph with a line that goes from roughly $7.4trn to less than $50bn in the beginning of 2017. That essentially is the level of deposits at the Federal Reserve held by the Treasury. When the US hit the debt ceiling back in February of this year, the US Treasury started to consume roughly $363bn worth of deposits that it had at the Federal Reserve. That money was essentially taken out of the Fed and injected into the economy, creating something that is similar to a quantitative easing policy. In annualised terms, the decrease in deposits with more than $7.4trn early in February to less than $50bn early in September amounted to annualised quantitative easing of $620bn. This is one of the factors that was behind the significant acceleration in financial asset prices.
You can see that once that ceiling has rolled over in early September, the Treasury begins to reveal its deposits at the Fed. And over the course of one month between September 8th and early October those deposits increased by $112bn. This is equivalent to quantitative tightening, which in annualised terms equates to $1.3trn. This is why we think we saw the low in long-term treasury yields and in the dollar early in October. And even though we believe that we’re going to see deposits decrease again from November on until the next debt ceiling rollover, we believe that from 2018 on as the US treasury deficit increases and a new debt ceiling negotiation takes place, these deposits are going to be revealed to levels that should be comparable to what we had early this year. And as a consequence the treasury itself is going to be performing with an amount of tightening on monetary conditions.
In addition to this, if we go to slide 16 of the presentation, on this slide you see a set of blue bars that shows the change in the size of the balance sheets of the Federal Reserve, the ECB and the Bank of Japan every year starting in the year 2000. And our projections for the change in the balance sheet of those three banks in the blue line for 2018 and 2019, and also the grey bars here show the change in the size of the balance sheet of the ECB. As you can see in this graph, 2017 on a year-to-date basis has been a year of increase in the balance sheet of the three large central banks, and this has been driven mainly by the ECB.
Between the end of this year and the end of 2019, all that purchasing power that was deployed by the ECB, and to less of an extent by the Bank of Japan, is going to disappear. We’re talking here about close to $2.4trn of annualised purchasing power that are going to go away. It’s very difficult for us to believe that the curves for both treasuries and bonds, which currently are affected by a significant negative term premier in the middle and long end, are not going to normalise. And such normalisation is going to trigger meaningful capital losses at least in external debt credit, where the duration of the benchmark is long.
Finally, the question that we usually get is where we see inflation, because most people don’t seem to be able to see it anywhere they look at. Before I get on to where we see inflation, let me just make a brief comment here, and state that approximately five weeks ago the Federal Reserve published a paper where they discuss two new indices of trend inflation that were developed by the Fed staff that have a much better statistical explanatory power of trend inflation than what the usual core inflation and core PCE numbers have had historically. Those two new data points that the Fed has added to its arsenal of tools see underlying trend inflation between 2.3% and 2.8% year-on-year and accelerating. And the publication of this paper coincided with a shift in rhetoric by many of the FOMC members towards a much more hawkish attitude.
With this said, we wanted to touch on four emerging market economies that have historically operated as the buffers that central economies have used to go to for spare capacity when the central or developed market economies reach full capacity. And those are the cases of the Czech Republic, Poland, Hungary and Romania, which are countries that have heavy trade linkages with the eurozone. And in these four economies we see very significant signs of inflation, which we believe are going to lead to an acceleration in inflation in the eurozone.
If you go to slide 17 of the presentation, the graph on the left side shows the case for the Czech economy, where the blue line is the measure of upward gap for the Czech economy, and here you can see that the economy is currently running at a level of growth that is 2% above what the potential is for that economy. In the past, this level of output gap has been consistent with inflation accelerating in the high single digits. And if you look at the grey line that shows the evolution of inflation, you can see that in the last nine to ten months inflation has gone from essentially flat year over year to above 2%, and we think it’s going to continue to accelerate.
On the graph on the right, we see the case for Poland, where the brown line shows unemployment at the all-time lows. Poland’s unemployment today is the lowest we’ve ever seen since Poland became a market economy. Inflation, which is depicted by the grey line, has accelerated from being negative a year ago to be more than 2% now. And wage growth, which is depicted by the blue line, is running at 7% year over year. So far we think that we have not seen inflation in Poland, because up until a year ago there was a significant influx of Ukrainian workers, which allow this economy to grow without producing inflation; however, it is difficult to believe that the current level of wage growth can be maintained without inflation, because you would need to have extremely high productivity growth levels in order to support further non-inflationary growth.
If we flip to page 18, here we see two economies. One of which exports roughly 80% of GDP to the eurozone, which is that of Hungary, which are running at red hot levels, and where rates are at close to their all-time lows. The case of Hungary on the left side of slide 18, you can see that unemployment is close to the all-time lows, inflation has accelerated to roughly 3% year over year, and wage growth represented on the left-hand side is running at 13% year over year. It’s absolutely impossible for this economy to be able to maintain this level of growth in wages without triggering very high inflation. In the past this level of wage growth has been consistent with inflation in the two digit zone. Finally, in the case of Romania, we’ve just started to see the central bank react over the last few weeks as wage growth reached 20% year over year, and inflation went from significantly negative numbers 18 months ago to levels just under 2% and accelerating now.
So, to sum up, let me finally take you to slide 29 of the presentation. We do believe that the fundamentals for emerging market countries are substantially better than what they have been on average for the last eight or nine years. However, given what concentration in currency position in these, and given what concentration in both positioning and valuation is on the credit side, also given what we think is going to happen with the treasury and bond curves, we believe that we are going to have an additional large adjustment down in asset prices. And that will hopefully give us the opportunity to invest our capital in the healthier segments of the asset class at more attractive valuations. And until that happens we’re likely to retain the defensive posture that we have had. And with this I’m going to stop here and open the floor for questions.
ZACK WROOT: Thank you for the update Guillermo. We’ve had a question that came through during the call, and that question is: has your view about the risk that the US may pose to world free trade changed; and how likely is it in your opinion that the US withdraws from NAFTA and what would be the impact on the Mexican currency?
GUILLERMO OSSÉS: Let me start with the impact on the Mexican currency, and then I’ll answer the rest of the question. If the US pulled away from NAFTA but stayed in WTO, most Mexican export products would see an adjustment in prices of roughly 4 to 5%, because that’s how much tariffs would increase on exports from Mexico to the US. In theory this means that for a currency that is in our estimate between 5 and 10% undervalued, you would not need a significant adjustment; however, we do think that the impact in the investment climate, and the impact on expectations would trigger a depreciation that everything else equal could take that currency probably 10 points weaker from where we are – which would still be a stronger level than what we saw in January of this year when the market was in complete panic.
Now, with respect to the likelihood of the US pulling away from the international trade agreements, early this year when we were much more aggressive with respect to our views, I mean our positive views on the asset class, we used to discuss with our clients the findings of an analysis performed by the Peterson Institute of Economic Studies, where they simulated the imposition of tariffs on the Chinese and Mexican economies, which essentially implied an abrogation of the duties that the US has under WTO or NAFTA. And what the Peterson Institute study indicated was that the US would experience contraction in GDP growth for approximately three years after the imposition of the duties, assuming retaliation by Mexico and China. And it would take another two to three years for GDP to get back to the levels that we had prior to the imposition of US duties on Mexican and Chinese imports.
So, the reason why I’m dwelling on this is because it is essentially economic suicide for the US to actually get out of arrangements like WTO or NAFTA, and we think that US authorities know this. And this is probably the reason why nothing has happened yet. We believe that it’s extremely unlikely the US will pull away from WTO or NAFTA, but in a market with positioning that is as crowded as the current market is, and with valuations quite stretched, the stress associated to that theory could trigger significant corrections. And that is one of the reasons why we are so cautious at this point.
ZACK WROOT: Thank you Guillermo. This brings us to the end of this web conference on the GLG Emerging Markets Debt Strategy. And thank you all for dialling in today.
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