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Emerging market debt has had an annus horribilis in 2018 due to a surge in the US Dollar Index, a hawkish Fed, threats of a trade war and financial crises in Argentina, Turkey, Brazil and Pakistan. Apart from India, I have no interest in local currency emerging market debt, though some currencies have fallen by 20-30 per cent in the past two years. At an average yield of 6.4 per cent for US dollar-denominated debt, there are pockets of value in this assets class. As in the 2013 "taper tantrum", the rise in US Treasury bond yields will continue to pressure the asset class and the Powell Fed could well raise the Fed Funds rate another 100 basis points in 2018-19 while shrinking the Fed balance sheet below $4 trillion.
Yet even the Fragile Five (Turkey, Brazil, South Africa, Indonesia and India) current account deficits are 40-50 per cent below levels in 2013 and emerging market currencies have fallen 35 per cent since 2013. The Achilles heel of emerging markets is its $11 trillion sovereign debt, up from $5 trillion in 2007. US monetary tightening makes an emerging market debt crisis inevitable, as the world learnt the hard way in 1998, 2013 and now. The 350-point spread that US dollar-denominated emerging market bonds offer over US Treasuries is historically not very attractive in such a macro milieu. I can easily envisage another 80 basis points in spread widening on the key JPMorgan Emerging Markets Bond Index.
After all, Wall Street expects between three and four more interest rate hikes by the Powell Fed in 2018 and 2019. With the US economy adding 200,000 jobs monthly, the unemployment rate down to 3.8 per cent, fiscal stimulus and potential wage inflation, there is every reason to believe the yield on the 10-year US Treasury note could rise to 3.5 per cent. This will mean that spread widening in emerging market debt will become inevitable. The politics of the US-China trade war, crude oil supply shocks and synchronised global growth pressures all make emerging market debt a treacherous minefield for investors next year.
Financial crises in emerging markets can be as brutal as they are protracted. The Argentine peso plummeted 40 per cent despite a 1,000-basis-point interest rate rise by the embattled central bank in Buenos Aires until President Macri, the darling of Wall Street after decades of Peronist fiscal profligacy, was forced to seek a $50 billion IMF bailout. Now that a IMF programme is in place and a pro-market, pro-business government is in power, Argentine US dollar sovereign debt could offer value in the 10 per cent yield to maturity level. I see no investment case for Turkish sovereign or corporate debt. The prospect of a double dip recession and a populist victory in the October election makes me reluctant to recommend Brazil's sovereign debt at current levels.
Egypt has made epic financial and political sacrifices to keep its commitment under its $12 billion IMF programme intact. Preside Sisi's government has undertaken structural reforms (eg, fuel subsidy cuts) that even Hosni Mubarak had eschewed and the central bank governor has bought down inflation without sacrificing economic growth. There is an embryonic investment case for Egypt's US dollar sovereign debt. The offshore exodus from emerging markets will continue as US rates and King Dollar rises. However, amid the horror stories, there are compelling sovereign and corporate credit stories that can make serious money but only, to evoke the ghastly US television game show, if the price is right! For now, US equities is the winner risk asset de jour!
The surge in the 10-year US Treasury note yield last week to 2.96 per cent after a month of narrow range trading lead to a widening of the two- to 10-year US Treasury note spread, a ballast for bank stocks. The reason was less any specific US economic growth data point than a rise in Japanese government bond yields due to a shift in the Bank of Japan's monetary policy and news that the new Mexican President Lopez Obrador wants a new trade deal with the US by August. The strong US corporate earnings season and 4.1 per cent second-quarter GDP growth data has also abated fears of US recession risk. Wall Street is also fears that now that Russia has dumped half its US Treasury bond holdings after the US tightened sanctions on Kremlin-linked oligarchs, Beijing might follow the same strategy in response to Trump's tariffs threats. China, after all, is the world's largest holder of Uncle Sam debt at almost $1.2 trillion.
The writer is a global equities strategist and fund manager. He can be contacted at mateinkhalid09@gmail.com.
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