Rising Risk, Surprising Value - Navigating EMD in 2023

How do you balance attractive yields and potential risks? In EMD, we are starting to see the emergence of value across some issuers and currencies, plus volatility that could create further pricing dislocations. But we shouldn’t presume that this sets the stage for a pure beta rally; we also expect to see ongoing challenges from high debt levels, tighter DM monetary policy, China’s structural deceleration and sentiment that has yet to capitulate.

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Tim Peach:

Good morning to those of us in the US, and good afternoon or evening to those who are joining from elsewhere in the world. Thank you for joining us today for 45 minutes of, I hope, candid conversation about how to navigate and profit from investing in the debt of emerging market countries. Now, I can safely say that I doubt we have any joiners that support Croatia or Japan, but we were very keen, for Phil's benefit, to ensure that we didn't cut into the match between Korea and Brazil later on this afternoon.

For the many of you that do not know me, I'm Tim Peach and I'm responsible for our interaction with global investment consultants at Man Group, many of whom have active engagement on our EM debt strategies. I'm joined today by three of the members of the Man GLG emerging market debt team, Guillermo Ossés, Phil Yuhn, and Lisa Chua.

I'm going to start off with a handful of pre-prepared questions for the team, but I want to remind you all that you all have the opportunity to submit questions by the question submission box within the platform. We'll try our very best to answer as many of those as we possibly can. Otherwise, we'll revert after this call.

Before we get going, I need to start off with a little bit of housekeeping. Today's call is only intended for clients and prospective clients of Man Group. If you do not fit in these categories and in particular if you're a member of the press, please drop off the call now. No part of this call should be reported or quoted. It is entirely off the record.

Without further ado, I will start off with my first question to Phil. Phil, we've seen a dramatic development in both geopolitics and in financial markets this year, and your team's been defensively positioned and benefited from that this year. What does the opportunity set look like for EM dent from this point on?

Phil:

Yeah. Look, we've obviously had a lot of a volatility in the markets, the draw down as you mentioned before. With that, there is starting to become a lot of compelling valuation within the markets. But it's two sided. It's both on the long side as well as the short side. The reason for that is because with the draw down, we're seeing an uptick in volatility, not just in our asset class but risk assets in general. With the volatility, you start to see a growing dispersion within the asset class. If I were to illustrate that with one example, if you go to slide number eight, you can see that on the FX side of our universe.

When you look at the slide, what this showed you is all the individual lines here, which represent the various EM currencies in our universe. It's a measure of valuation for these currencies. It's what's called the real effective exchange rate. The Y axis shows you the percent deviation of that exchange rate with regard relative to its historical five-year average. So, in simplistic terms, you can view it as a measure of cheapness and richness.

When you look at the beginning part of this time horizon back in 2017, you can see that the dispersion was quite narrow and that was because of quantitative easing. We were in the midst of a large abundance of quantitative easing, all that liquidity then superficially suppressed volatility, and then in correlation started to converge to one. That's what you can see in this picture here. You can see that the valuations traded in a very narrow bandwidth between plus 10 and minus 10%.

As you go through in time, you start, you hit covid in 2020, that's when you start to see the first dispersion. Because from a fundamental perspective, covid hit countries differently and the valuations reflected that. More recently, with monetary policy tightening and with quantitative easing now turning into quantitative tightening, you've seen even a bigger dispersion in terms of valuation. That's what we mean by the opportunity set now is growing in terms of getting some attractive longs and potentially some shorts as well, too, on the other side.

If you go to the next slide, you can see it even more clearly. It's the same metric evaluation on the currency side, we're just now looking at a snapshot. So, we're showing you period pre-covid and where we are today. You can see even more clearly just how much that dispersion has grown. It's not just in the FX side in our space. We also see that in other segments in our currency, which is a dial denominated space. So, if you go two slides over, what you see on this slide here is the spreads in the hard currency countries in our emerging market are currency sovereign index. So, what's called the ending.

The solid blue line shows you the mean spread of these countries within the index. The bars show you the dispersion of spreads in those countries as measured by one plus one and minus one standard deviations. And we trimmed out the outliers, so the 10% widest and the 10% tightest ones. What you can see is a trend similar to what we just showed you in the FX side. If you look at the QE period before covid, you can see one absolute spread levels are at fairly tight levels. But more interestingly, number two, if you look at the dispersion as measured by the bars, you can see here, too, it's trades in a very narrow band. And then once covid hits, and then once QE turns into quantitative timing, you can see the dispersion has grown to an extent where the dispersion today is even wider than it was during the depths of the global financial crisis.

So, we believe that now we're in an environment where instead of just having to go directionally long or short beta, which is what you were essentially forced to do when volatility was suppressed. Now, you can generate alpha by picking the winners and avoiding the losers.

Tim Peach:

So, Lisa, with great dispersion, there are obviously more RV opportunities. Can you elaborate a little bit more on what you expect the winners and the losers to be?

Lisa:

Sure. Thanks, Tim. Phil's already highlighted how essentially dispersion across the asset class is really at the highest at record level, the highest that it's been at for quite some time. When we think about this space, for example, on the dollar denominated debt side, I would say on the high yield side, we're starting to see opportunities that we haven't seen in quite a while. But you really still need to be careful about where you're selecting within that space. So, take a country like Ghana for example. A country like Ghana is a country that they just announced local debt restructuring earlier today. They're likely to restructure their external debt. Just a little over a year ago, these bonds were trading at around bar. But now Alisa's starting to price in more of the default risk with bonds in the 30. So, we're starting to see this valuations improving. But again, you have to pick and choose where you're investing because yields won't always convert to return if there's more default, which we started to see.

You contrast that, for example, to the investment grade side, where there's actually, even though it's in the strongest segment of the market, there's still some short opportunities there because of how rich valuations are in some of these names. In some of these issuers on the investment grade side, we're at spreads that are close to the tightest level that we've been at, pretty close to the tightest level in the last 10 years, for example. A country like Indonesia. In five year CDS, so you can go short five years out in Indonesia. At around 90 basis points right now, which is both of the tights that we've been at for the last 10 years.

But also, the context of that in a context where TBOs in the United States, one year out you can blend to the United States are at high 4%, not at 0% anymore. So, you need to be much more conscious of the valuations and that. I would say, broadly speaking, opportunity is more on the high yield space. On the investment grade space, many of evaluations are still rich, although there has been volatility even in that space. So you need to be dynamically nimble. Hungary is a perfect example of that. Those spreads started the year at 90 basis points, went all the way to 350. So, the range has been pretty wide. Just staying nimble and being conscious of that.

 

Tim Peach:

Yeah, is that the same case in the local currency log?

Guillermo:

Yes. To a large extent it is. Think about it. We started a year with innovation of Ukraine by Russia. That triggered movement of capital from countries that were perceived to be commodity importers, starting with Eastern European ones, but also going on the way to the Asian countries. Capital went out of those places into countries that were perceived to be of high quality and commodity exporters. You ended up with a universe where there are some currencies such as those of oil in Hungary, the Czech Republic. But if you were to have a normalization in the [inaudible 00:09:11] of energy to Europe or not, then those crisis will look 20 points cheap to where they should be. We're not saying that that will necessarily happen, but you have that potential.

In addition to that, if you can go to slide 10, I think, you also have a much more variety universe of fields that you can take advantage of. In this slide that we're sharing, the yellow bars show what implied yield in our currencies were before covid happened. You could see that they were quite bunched together. Today, the universe is completely different. You can play long or hard with positions and some of these currencies have become cheaper, and sure the other ones. And you do get paid to take that risk.

Tim Peach:

How about from a treasury point of view? Obviously, we've seen a big sell of treasury this year. How does that impact your views?

Guillermo:

Well, this is an important part of the reason why we are emphasizing the ability to produce returns out of running aggressive longs and shorts, forwards and onwards. The source effects return in our asset class, in our view today, really comes from this dispersion of evaluations.

If you look at the indexes as I call here today, they aren't really all that much cheaper than what they were at the end of last year. On a year to day basis to the end of November, they are below index. Our currency bond index goes down 15.5%. Now, if you take into account that the 200 basis points widen in 10 treasury years, we'll have triggered the drag of 16.3%, multiplied by the duration of the index. And Russia produce an additional drag of 3.2%, and that was neutralized by a positive carry of close to 5% dish points. If the index was today where it was at the end of last year, it will have to be done for 10.6% on the year.

So, it's only 90 basis points cheaper than where it was on December 31st, 2021. When you apply the same logic to the local bond index, the local bond index actually looks a bit more expensive. The impact of treasury yields on the local index would have produced a drag of 11.1%. Russia produced a loss of 7.5% year today, and there was a positive carry for the 11 months of 4.4% for a total loss of for 10.2%.

If the index was today at the same level of intrinsic value that it had at the end of last year, the index is going down 12.5% on the year, which means that it's actually a bit more expensive now than what it was at the end of 2021. And it's comparable to where it was at the end of 2020. So, the nice thing about today's environment is the very high level of cashiers that you can get out of your high quality interest rate products. Which if you combine with the access returns that you can get out of running long and shorts in this rich universe and opportunities, then you can put some decent returns to that.

Tim Peach:

So, your views appear relatively contrarian, and I guess that won't be a big surprise to many of those on the call. But your peers clearly feel evaluations and yields are so compelling that the best opportunity [inaudible 00:13:16] in that meter. What's the counter like?

Phil:

Let's start first with why our peers are long beta. One of the main reasons is because they've always been structurally long beta. The reason for that is because, for the most part, it has worked historically. But keep in mind the environment where that kind of strategy worked. It was an environment where growth differential between EM and DM was quite favorable towards emerging markets. It was an environment where levels of debt and EM were at fairly reasonable levels. And it was a period where, up until recently, quantitative easing was in abundance, so there was a lot of liquidity to check into the markets. So, all three of those factors helped to be in a very positive data environment.

Where are we today? Now all three of those trends are reverting the other way. The growth differential that favored EM is no longer there. The difference has all but disappeared and we think that's structural. The other part is that the GDP path. If you look at what's happened in the post global financial crisis era, debt to GDP for almost every EM country has been on an upward moving bent to a certain significant level.

The third part, as we mentioned now, we're going from an era of quantitative easing to an era of quantitative tightening, which is further complicated by the fact that we're going also from a low inflation environment to an environment where we're seeing inflation levels that we haven't seen for most of our lifetime. When you look at that, it looks as if now it's no longer the supportive beta environment, but one where alpha is going to be generated through going through the long and shorts and playing that dispersion that we mentioned before.

Where we see that data no longer playing out with recent data, so if you go to slide number six. On this slide, you see the blue line there. Blue line shows you the rolling five-year return that you would get if you were long, the emerging market debt asset class. The way we measure the in debt asset class is buying being long, is 50/50 blended index. So, 50% our currency, 50% local currency. Five years, we pick that because that's a, I think, one could argue that's a fairly long market cycle.

You can quickly see what we mean by how the data strategy has worked for the most part. If you look, up until recently, any rolling five-year period, you've always had positive returns. There were periods where you got close to zero, but once it got there, it started to go back up. But look at what's happened over the last year. For the first time over the past year, you're actually now seeing meaningful negative returns, which most of our audience is obviously aware of.

Now, the other argument to make as to why people always long beta, is they say, well again, over a long enough horizon, the carry will compensate you so you should always have positive returns. We show you the carry that you get by being along these markets with the yellow line. That's the cumulative carry over a five-year period. You can see that it is correct. The carry can be very large, at average between 35 and 40% points over any five-year period. And yet, in spite of that, you've seen that over the past year you've had negative returns even with that high carry.

When we talk about the beta strategy, even though we've shown you the arguments for why we think an alpha strategy will work out, the market still hasn't adapted to this new environment that we've seen over the past year. So, if you go to the prior slide, what you see in the prior slide here with the solid blue line is the rolling one year beta of EM debt total return fund managers to that 50/50 blended index. Keep in mind that total return fund managers are not beta managers, they're alpha managers. When you look at the beginning period here in 2017, you can argue that even at that period when it was at the lowest point over the most recent six-year period, even at that time, an average beta 0.7 is fairly high for a total return fund manager to run.

But look at how that beta's evolved since. Since then, the beta has crept gradually upward. There were periods where your average peer was running a beta above one, and that's where it is today is right around that one level. That goes again to what happened. Why are they running this even though clear the beta's no longer working? It's because in the past with quantitative easing, with that dampening volatility, you had no choice but to either go long beta to generate the out -performance or to go the other side and go underweight or short beta. Clearly, our peers have chosen to go the long beta space so they haven't really yet adapted to this environment where we think alpha will be better than going to beta.

Tim Peach:

Okay. This looks like an area of differentiation for your process. We hear many managers talk about valuation and fundamentals, but not so much about market positioning. Maybe you can just talk a little bit about how you monitor it and how you incorporate it in your investment process.

Phil:

Yeah, sure. One obviously example is just looking at the rolling one of your beta, but we have more sophisticated tools beyond that to get to that next level of granular detail. One example of a tool that we have is we look at the speculative positioning in the currency market by the futures market. That's publicly available data through the IMM. But we also have proprietary tools. We have a set of tools where we look at the near term return streams of all of our biggest peers, and we regress those return streams against a set of global risk factors. What we're doing essentially is reverse engineering how market participants are positioned. The reason why we do that is to identify where the crowded trades are and where the uncrowded trades are.

I already showed you that our average peer in the total return versus running and being full beta, but we want to know where are they expressing that. If you go to the prior slide for this one, you can see the output of the regression that we run. This is the output for our total return fund managers. You see the coefficients, the global risk factors, that we've regress against. When you think about coefficients, for those that are not familiar with regressions, you can essentially think of this as beta. How much beta they're running to each one of these global risk factors.

So, the one on the left labeled and EMBIG is the sensitivity of our total return fund managers in beta terms to the investment grade component of the hard currency sovereign index. The one on the top is their exposure to the high yield segments universe in both frontier markets and corporates. And in the bottom right, the one that's labeled only plus, is their exposure to the EMFX space.

When you look at this, you can see that where they express the largest overweights in terms of risk is in the high yield component. So, let's see the coefficient on the upper right where they have the most exposure. That's not surprising. If you want to try to outperform by being long beta, you want to be in the highest beta space with the highest yield, and that's where they're there. For us, the way we do this with fund positioning is to identify the crowded trades to avoid, the uncrowded trades to enter. We marry that with the fundamentals and valuation process.

Tim Peach:

Okay, so I'm conscious that we have only got 10 minutes to go, so I'm going to go to the first question from the audience. I've delighted it from an investment consultant. So, that's a good time. The question is, would you anticipate the same results when integrating EM debt corporates into the blended benchmark? Or is that not considered in your analysis?

Phil:

It wouldn't change anything because you see positive correlations. We mentioned before how the correlations have started to go towards one. When you look at the SenV, which is the corporate index, the return stream has been very similar and the correlation has been very subtle. So, the analysis would still.

Guillermo:

Also, one thing that it's worth having is that the environment in which we're going is going to an environment with higher default rights across EM sovereigns. Historically, although there are some exceptions, whenever you see a default in a server, the majority of corporates follow suit. So, if you are running a strategy with a large exposure to low quality credit, even when you diversified into corporates, you want to be sergeant to under-risk anyway. Which is also the reason why the analysis wouldn't change.

Tim Peach:

Are there any other reasons why, more broadly speaking, in your investment portfolios you don't incorporate exposure to corporate?

Phil:

Yeah, sure. One answer to that that we've seen is the lack of liquidity in the markets in terms of corporates. We know we're in an environment right now where the sell side banks are running 10% of the balance sheets that they used to run for the financial crisis. So, liquidity is already at a premium. When you layer in the fact that corporates, when you look at trace trading data, which is the independent data source that captures all trading in the corporate space, you can see that out of the 700 [inaudible 00:22:38] issuers that they track, there's only 13 that have daily trading volume above 10 million. That's at the issuer level, not at the independent bond level.

So, even if you're bullish on corporates, yeah maybe you can add in and lay into a trade. But the bigger risk is if something were to happen, like we've seen in the last year and a half, two years, covid locked up, for example. How do you exit out if everyone's trying to get out of that same narrow liquidity? That's one argument for why one needs to be more careful in terms of corporate exposure.

Tim Peach:

Okay, and a follow-up question, more on the basis of relative EM debt versus developed markets. Most investors have multi-asset exposures and look at EM debt opportunities and risks relative to other segments of credit. How do you see EM debt relative to EM IG and high yield?

Guillermo:

Well, we go back a little bit to this idea of the opportunities being in the dispersion evaluations rather than in being just along the asset class. We have to recognize that a high quality fixed income class becomes essentially cheaper. We think that you can enhance the expected return that you can get out of the high quality fixed income by taking advantage of the excess returns available in our asset class. Even on the other hand, you just go along a mix of high yield revenue, low quality credit with EM currencies, then you're probably giving away a substantial portion of the stream of returns that you may get out of the higher yield. So, you can enjoy high quality fixed income you've led.

Tim Peach:

In terms of political uncertainty, Lisa, you see Brazil just had elections, South Africa is facing uncertainty around its president, and there are other countries like Peru that are basically uncertainty. Does that focus the team on the concerns, not just the opportunities?

Lisa:

I think we need to be even-handed when looking at the opportunities and also looking at the risk factor. I think that we do a good job of thinking about risk-adjusted returns and how to enhance those and how to get stronger risk adjusted returns. We've talked a little bit about our process throughout this, fundamental valuations and positioning. On the fundamental side, obviously we're also considering factors like geopolitics and how that could impact the trajectory of a country. You obviously want to be long, those countries that have strong fundamentals that are improving with evaluations that are compelling and the positioning is uncrowded.

We are seeing more and more geopolitical risk within the region that adds to that. But on top of that, we're thinking about structurally, medium term. Who's going to be able to navigate it? For some of these countries, we're thinking about on the fundamental side for example, is what are their debt sustainability issues? What are their balance sheets look like? Do they have a floating FX regime where they can adjust to restore macro balances and so forth?

Look, I would say, I've worked with General [inaudible 00:26:15] for over a decade now. We spend more time talking about... I talk to them more about the markets probably than I do talk to my husband, when you think about waking hours, actually. We're thinking constantly about the interplay of all these dynamics. So, in a country like Brazil, we are thinking about, okay, looking past... Obviously, the electoral [inaudible 00:26:38] issue, but thinking past that. So, even prompt issues like, okay, they have fiscal imbalances, they higher debt burden, and how much of this is being priced in?

 

Tim Peach:

Can you put a little bit of meat on the bones in terms of when you look at these are the opportunities that you talk about that coming out of this dispersion? Maybe you can give the audience in the last few minutes just a few ideas of where you might like to be, whether you're considering being all, or whether that opportunity to not be all, and where the areas of specific concern remain.

Guillermo:

Yeah, I'll give an example and then I'll turn it over to maybe [inaudible 00:27:13], who has any other remarks. You think about where we were just at the start of the year. At the start of the year, many investors or participants and market participants in the space were still thinking about, let me just grab yield, let me just chase beta. Issuers like PEMMEX, which are we think about sovereigns. We also ask about corporates, we also think about quasi sovereigns, which are extensions of the sovereign risk. It has fundamental issues. It has cash flow issues. But at the same time, the question is what's getting price into valuations? What's getting put into positioning? Initial like PEMMEX at the start of the year, many investors were chasing at a 6% handle. That reached level of north of 12% at one point just a month ago. Now, we're at a 10% handle as the positioning got cleaned up.

So, it's understanding how the positioning could impact the valuation and think about all those dynamics together. When we think about this, we're thinking about the countries that will be able to adjust. That will be able to either provide support to some of the body sovereign issuers. And if they can adjust on their own to a more difficult macro environment, who are the ones that are going to have multi-lateral support?

Let me try to talk about the question in two ways. One is to make it a brief list of the areas where we think the combination of [inaudible 00:28:41] and fiscal fundamentals is good enough to warrant investing. If you start from America to the east, places like Mexico, Panama, potentially Ecuador, and I'll come back to this, Chile, Peru. If you go to Africa, places like Ivory Coast, Kenya, within times invested in Angola, Egypt, and I come back to this. And we look at Asia, the countries that are in Southeast Asia, most of them have combinations of balances and fiscal fundamentals that at a certain level of evaluation it would make sense to own.

Now, what's important here is that the best way to produce a return is to begin those opportunities that offer the value. Digital political element in with regards to uncertainties that they were alluding to earlier is quite important here. Countries like Ecuador or Egypt are quite important geopolitically for the US and Western Europe. Even though the credit situation is complicated, they will get outside support.

So, if you win the portfolio, running longs and shorts, you might at times get caught in an asset that will default on you. But at the overall portfolio level, if the portfolio is balanced, your hedges will moderate the market to market risk. If you end up on top of a yield coming from high quality iteration, then you can make pretty decent returns with relatively muted volatility, which is very different from just being long. All the assets have a high yield without much discrimination.

Tim Peach:

Well, sadly, we're out of time. I'd like to thank Lisa, Phil, and Guillermo for your candid contributions. And to the audience, thank you very much indeed for joining us today. If you have any further questions, please do speak to your regular contact at Man Group and we'd be very happy to follow up with an answer. Wishing you a very happy rest of the day. Goodbye.