Outlook 2016: Wider spreads, modest returns for EM in new year; deals likely from Kuwait, Qatar

By Christine Van Dusen

Atlanta, Dec. 31 – The relief rally experienced by emerging markets bonds at the end of 2015 is expected to wind down in 2016, a year that industry experts say will be marked by wider spreads and modest returns for the asset class.

“Modest positive returns are achievable next year simply if spreads return to historical means,” said James Barrineau, co-head of the Emerging Markets Debt Relative at Schroders. “Moving into 2016, we see the internal issues for the asset class as slowly healing.”

Since the “taper tantrum” of May 2013, emerging markets currencies have lost about 40% of their value, he said.

“This was accompanied by liquidity into the asset class drying up, credit default swaps widening significantly and currency volatility picking up,” he said.

The resulting underperformance of emerging markets assets lowered valuations significantly, according to a report from Goldman Sachs.

For the new year, EM fixed-income is expected to show annual returns of 4.9%, according to a report from UBS Investment Bank.

“EM corporate profits have contracted by 26% since 2011 in U.S. dollar terms and 2% in local currency terms,” UBS said. “In the tough market conditions of recent years, many firms have focused on preserving market share, rather than maintaining earnings or profit margins. A pick-up in earnings and margins would provide solid evidence that the worst is over for EM investors.”

Yields likely to remain low

The last time EM underperformed for an extended time was from 1997 to 2001, said Bhanu Baweja, global head of emerging markets cross asset strategy at UBS.

“Could 2016 provide a similar inflexion point? We would bet against it,” he said. “The direction of U.S real rates, EM balance sheets and China’s nominal growth are almost diametrically opposite, implying a narrower growth premium and a higher cost of equity over developed markets.”

Global trade and commodities could improve somewhat in 2016, “and this should help improve returns from 2015,” he said. “But that’s a low bar.”

Yields are likely to remain fairly low, according to the UBS report.

“Global credit trends will likely be mixed, with euro-area credits outperforming EM and low-quality U.S. credits,” UBS said.

Issuance should increase

Overall, issuance from emerging markets sovereigns – excepting quasi-sovereign issuers – is expected to total $38 billion in 2016, up from $32 billion in 2015, according to a report from Morgan Stanley.

Dollars are likely to remain favored, the report said, though euro- and Japanese yen-denominated deals will increase too.

Investors should focus on debt denominated in dollars, not local currencies, according to a report from UBS.

“EM currencies are highly volatile,” the bank said in a report. “Given that idiosyncratic difficulties can be common in emerging markets, we recommend a portfolio which holds a combination of EM sovereign and EM corporate bonds, to diversify risk.”

Lat-Am in focus

Looking to Latin America, the economy is expected to remain in a recession in 2016, with a modest recovery projected for 2017, UBS said.

“Latin America is still adjusting to lower commodity prices and to weaker capital inflows in a global environment where exports are finding little traction,” the report said. “Moreover, there is the underlying fiscal crisis in Brazil, which keeps the largest economy in the region mired in recession.”

Brazil will remain in the spotlight in the new year, market sources say, as it grapples with ratings downgrades, political scandals and other events that put pressure on bonds in 2015.

“At the end of the year, Brazil's bonds were significantly wider, as the president faced impeachment and ratings agencies downgraded the sovereign to junk,” a trader said. “This will pose severe problems for a country with Brazil's deficits and external indebtedness, public and private.”

But the pace of economic contraction in Brazil should slow, a trader said, while other emerging markets should see a pick-up in growth.

EM faces headwinds

While Mexico, Poland and Hungary are expected to experience more robust growth in 2016, growth for EM overall is expected to remain at a below-trend pace amid global and local headwinds, according to a report from Goldman Sachs.

“Most EMs will face an external backdrop of relatively flat developed market growth rates and higher U.S. interest rates in 2016,” the report said.

Commodity-related credits will continue to struggle against low oil prices, and commodity importers like China “will continue to wrestle with large debt overhangs that will act as a brake on growth for several quarters,” the report said.

Kuwait, Qatar could price

Looking to the primary market, emerging markets corporates are expected to continue focusing on “maintaining good credit measures and will avoid taking risks of pursuing large corporate acquisitions,” said Alexandre Dray, an emerging markets analyst with Gimme Credit LLC. “Against this backdrop, we will continue having most of the corporate bond issuances used for refinancing purposes.”

Kuwait and Qatar will be well-positioned for issuance, given their stronger fiscal profiles, a London-based trader said.

“The low volume of primary supply should also benefit those countries,” he said. “Qatari issuance will also benefit from regulation that forces local banks to practically invest 85% of its securities portfolio into Qatari government and bank bonds.”

Bahrain, Saudi Arabia eyed

Bahrain will likely be active in the primary market, Dray said, given its fiscal deficits and low reserves.

The new year should also see the local-currency market in China grow in size and breadth of issuers, said Nuj Chiaranussati, an analyst who focuses on Asia for Gimme Credit LLC.

“This may slow down new issues by China into the external debt market,” he said. “Nevertheless, we still expect China – corporates and banks, primarily high-grade – to be the top issuer among global EM.”

Saudi Arabia is another likely issuer, another trader said, as the sovereign sees fiscal buffers deteriorate rapidly.

Commodity credits to struggle

In trading, commodity-related credits are expected to continue to struggle in 2016, Dray said.

“Oil prices will likely remain at very low levels,” Dray said. “In metals, companies built up huge inventories in 2015 and we will be seeing some de-stocking effects in 2016 before having a rebound in production levels in 2017 and 2018. Thus, companies with good liquidity levels and adequate maturity profiles will be preferred so that these firms can continue paying their coupons through the cycle.”

Commodity and energy names from Asia took a hit during the year, and the “outlook remains dim,” Chiaranussati said.

He pointed to China's Yanzhou Coal Mining Co. Ltd. and India's Vedanta Resources plc and PT Pertamina as likely underperformers in the new year.

High-yield Asia could lag

Also expected to underperform in 2016 are high-yield names from Asia, Chiaranussati said.

“Given that Asia high yield has done relatively well this year and outperformed other EM regions, we begin to feel that the Asian high-yield sector is fully valued now and could underperform in 2016 if the outlook in other EM regions starts to improve,” he said.

Investors are likely to look toward Asia's high-grade sector for better risk-reward profiles, he said.

India's bonds should also get support in 2016 and 2017 as a result of its strong forecasts for gross domestic product growth, he said.

Value seen in Finansbank, DIB

Other names that could show value in 2016 include Turkey’s Turkiye Finans Katilim Bankasi AS, a lender currently owned by the National Bank of Greece that will likely be sold to Qatar National Bank SAQ, another trader said.

Older perpetual bonds from the Gulf region could also have some value in the new year, he said, pointing to Dubai Islamic Bank PJSC's 6¼% notes.

Ivory Coast's peaceful elections in 2015, as well as its economic reforms, make it a standout.

In terms of duration, bonds with maturity levels below five years are expected to re-price to a limited extent, another trader said, and that further upside at current levels is unlikely.

One trader suggested avoiding bonds from Egypt, which has a weak fiscal balance sheet, and Ghana and Zambia.

“[Ghana and Zambia] will continue to struggle with falling commodity prices, power shortages, currency pressures, high inflation and fiscal deficits in an election year,” he said.

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