Outlook 2011: Euro zone debt crisis will color EM picture in 2011; single-digit returns likely

By Christine Van Dusen

Atlanta, Dec. 31 - If investors and issuers thought they could leave the European debt crisis of 2010 behind in the new year, they were wrong. The economic problems of the euro zone will remain a significant issue in 2011 and will continue to impact the picture for emerging markets debt, market sources said.

And given the tight level of spreads, the assets face more headwinds than they've faced in several years, said Nick Chamie, global head of emerging markets research for RBC Capital Markets.

"We could be looking at a situation of lower returns in 2011, which could temper some investor interest," he said. "But overall we expect in the long term that the secular trend of increasing global appetite for EM debt will continue to grow."

So while returns may not be sky-high, they'll still likely beat out those seen with U.S. Treasuries, and the EM asset class should see continued inflows, strong fundamentals, reasonably good risk appetite, and healthy volumes, sources said.

"I think the inflows into the asset class will still be positive and provide a positive backdrop for the asset class," said Luz Padilla, portfolio manager for the DoubleLine Emerging Markets Fixed Income Fund. "We may actually start to see more of an allocation from institutional money, whereas a lot of what came in 2010 has been retail. And I think the underlying improvement in credit quality is set to continue."

Bond-like returns

Emerging markets assets are expected to fare fairly well in 2011's environment of improving growth and abundant liquidity, according to a report from Barclays Capital.

"The best performance is likely to be in equities and higher yielding bond markets that behave more in line with equities," the report said.

Emerging market debt should continue to outperform U.S. Treasuries but earn bond-like total returns of 4% to 10%, sources said.

"I think people look at the EM debt universe and think it's still positive momentum to the underlying fundamentals and good valuation," Padilla said. "For an asset class that has the potential to deliver high single digits, an allocation to EM debt makes sense. And I think the low expectation for default risk is something that's going to be positive."

In order to obtain the equity-like returns that EM assets have recently delivered, investors will need to expose themselves to high-yield debt and the outsized risks that accompany the outsized potential returns, Barclays said.

Reaching for spread

In terms of trends in issuance, expect to see a lot of corporates and quasi-sovereigns bring deals to market, as opposed to sovereigns, Chamie said. And he expects to see names that haven't been in the market before, demonstrating an increasingly healthy appetite for EM risk.

"Beyond that I think you're likely to see a sort of continued move down the credit spectrum in EM, given the ease of acceptance for the highest-rated and the biggest issuers in the market," he said. "The desire to reach for spread out on the further end of the credit spectrum will remain quite intense."

Investors are expected to come back to the market with gusto in 2011, a Connecticut-based trader said.

"I think they'll come back ready to put some risk on the books," he said. "But accounts will be quick to reverse course if they start to see storm clouds."

Barclays' strategists favor high-yielders such as Argentina and Venezuela. And despite the inflation risk, "we like nominal bonds in Korea, Malaysia, Mexico and Peru," the bank's report said.

Latin America stays solid

Taking a closer look at these regions, credit fundamentals are likely to remain solid in Latin America and Asia in at least the first quarter of 2011, said Chamie.

The EEMEA region, however, will be a weaker spot, he said.

He remains bullish on growth, declining volatility and strong appetite for emerging markets assets.

"Global liquidity remains supportive but past peak," he said.

He expects markets to remain skittish with heavy contagion from Europe's debt problems. Near-term profit-taking is a risk, alongside a forecast for a stronger dollar and U.S. Treasury yields.

"There will be a lot of crosscurrents," he said. "You're going to have reasonably good U.S. growth, and that will be helpful, but at the same time, that U.S. growth will be accompanied by a stronger dollar and Treasury yields, causing headwinds for EM performance. So we could see returns of as much as 10%."

Argentina spreads could widen

Argentina could get a boost in sentiment in 2011 if the sovereign settles its $6.7 billion of defaulted debt with the Paris Club.

"But in our opinion it does not alter the country's ability to issue debt," RBC said.

The political scene in 2011 - in particular whether or not Cristina Kirchner runs for reelection - could create some volatility for the sovereign, RBC said. "We look for the possibility of changes in economic policy, driven by a potential change of government, to drive a continued contraction of Argentine spreads," the report said.

A higher chance of reelection could translate into higher spreads, RBC said.

Colombia, Venezuela in focus

Colombia, meanwhile, is likely to remain one of the most attractive EM stories, RBC said. Anchoring this will be the development of the sovereign's oil and mining sectors and an attractive investment and regulatory climate.

And Venezuela is expected to continue to see strength and improvement in 2011, RBC said, assuming that oil prices hold up.

"Taking into account valuations, some room for optimism on the political and fiscal fronts and considering that the government's FX policy as well as oil sector developments argue strongly in favor of the government remaining current on it external debt obligations, we believe that investors should continue to consider Venezuelan bond longs, though tactically," RBC said.

The strategists at RBC favor the sovereign over Petroleos de Venezuela SA (PDVSA).

"New debt supply risks should also be low in first-quarter 2011," the report said.

Russia, Turkey attractive

In examining Russia's prospects for 2011, RBC expects to see a far better year, with acceleration in GDP growth, a new privatization plan and a possible entry into the WTO.

Turkey should be another positive story in 2011, RBC said. The sovereign saw a surge in foreign portfolio capital inflow in 2010, with about $10.6 billion flowing into bonds. "We believe shorter-term money will continue to flock to Turkey in 2011," RBC said.

What makes the sovereign attractive, RBC said, is that its GDP growth is expected to remain among the fastest in the EEMEA economies, fundamentals remain strong, the banking system risk ratios are solid and the fiscal deficit is manageable.

The biggest risk facing Turkey is euro zone contagion, given the sovereign's reliance on external sources for funding, RBC said.

"The regions where we've seen less issuance have been Central and Eastern Europe," Padilla said. "Part of it is that there are still some sectors that are going through some clean-up. I would expect those trends to continue, and we'll see some issuance but not an overwhelming amount. As long as we see U.S. rates well contained, we'll see issuers that want to tap the markets."

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