Outlook 2018: Tighter EM spreads, lower return eyed as caution creeps in following ‘stellar’ 2017

By Rebecca Melvin

New York, Dec. 29 – Conditions that resulted in stellar performance in emerging market credit in the first three quarters of 2017 are expected to continue to drive gains in the coming year, but cracks that recently materialized in the space have given rise to some caution and tempered predictions for 2018.

The new year begins on the heels of a fourth-quarter stumble that hit several key markets, including Turkey, South Africa and Brazil. But total return remained “decent and new issuance was great,” a New York-based market source said.

Continuing strong economic growth, a weaker U.S. dollar and still attractive valuations are expected to support emerging markets, helping them rebound from recent weakness, at least for the first half of 2018, Morgan Stanley strategists wrote in report published Nov. 28.

“2018 will be a year of key transitions, with inflation rising and monetary policy tightening, while important parts of the global economy, namely China and the United States, are expected to see growth moderating,” the strategists said, noting stellar performance in key benchmark indexes for much of 2017.

Likely passage in December of a sweeping Republican tax reform bill in the United States could put additional weight on emerging markets as the usual cautions apply, including expectations around U.S. interest rates and the dollar, political risk around national elections, the price of oil and other commodities, among other things.

For the year through Dec. 18, the gain for iShares J.P. Morgan USD Emerging Markets Bond ETF was 9.98%. This ETF and others seek to replicate investment results of the J.P. Morgan EMBI Global Diversified index, J.P. Morgan CEMBI Broad Diversified index and J.P. Morgan GBI-EM Global Diversified index.

The Intercontinental Exchange BofA Merrill Lynch emerging market index put total return at 6.9% for the year through Dec. 18.

Going forward, country and region selection will be important, including weighing entry points given levels attained by sovereign and corporate emerging market credits in 2017. EMBI spreads tightened to 331 basis points from 366 bps during 2017, a market source said.

Argentina, Russia and Mongolia, among sovereign credits, while richer, are still fundamentally improving, and the long end across numerous curves are recommended in light of steeper credit curves and much lower yield on 30-year Treasuries, according to Morgan Stanley’s outlook report entitled, EM-bracing a Bullish 1H18.

Similarly, the outlook for emerging market corporate debt is lower, but “still positive for returns in 2018, with expectations for spread tightening, given a strong fundamental and technical backdrop,” said BofA Merrill Lynch’s Kay C. Hope, director of corporate credit research for Emerging Europe Middle East and Africa, or EEMEA.

Higher U.S. rates in 2018 will prevent total returns from reaching the levels seen in 2016 and 2017, but total returns of 1.9% for EM investment grade and 5.4% for high yield are estimated on the back of tighter spreads, according to BofA Merrill Lynch’s forecast.

BofA Merrill Lynch’s total return baseline estimate for EM corporates is 3.2%. A better-than-expected scenario could raise total return to as high as 7% to 9%, and a worse-than-expected scenario could cause a negative 1% return, according to BofA Merrill Lynch’s outlook report, GEMs Corporate Credit Year Ahead, 2018: Tighter and Tougher.

Latin America outperformed handily, at least in part because its starting place was wider, Hope said. Since some of the corruption scandals in the region caused investor sentiment to plummet in 2015, “Latin America has done very well,” she added. By region, 2017 total return stands at an estimated 10.6% return for Latin America, 5.2% for EMEA and 4.9% for Asia.

Spreads to tighten

The BofA Merrill Lynch return forecast for 2018 is dependent on its estimated trajectory for U.S. Treasury yields, spread targets and default expectations, and is highest for Latin America at 4.7% and lowest for Asia at 2.2%.

The bank’s baseline scenario assumes that emerging market investment-grade corporate spreads move tighter by 11 basis points from current levels of 130 bps, and largely in line with U.S. IG spreads.

Latin America IG is expected to tighten the most by 21 bps to 180 bps, assuming there are no major negative shocks around renegotiation of the North American Free Trade Agreement or Mexico’s presidential elections. It also expects Asia IG spreads to tighten by 11 bps to 105 bps and EEMEA IG spreads to tighten by 11 bps to 135 bps.

“Risks to our outlook for spreads are wider U.S. IG spreads, which spill into our market, escalation in geopolitical risks, a collapse of Nafta talks and wider sovereign spreads,” according to the BofA Merrill Lynch outlook report.

For emerging market high-yield spreads, BofA Merrill Lynch’s baseline is more optimistic, based on an expectation for a slow unwind of U.S., E.U. and Japan central bank asset purchases, which support the continued reach-for-yield across asset classes. It expects Latin America HY spreads to tighten 45 bps to 440 bps, EMEA to tighten 35 bps to 285 bps, and Asia to tighten 28 bps to 370 bps.

Risks to its baseline forecast are higher market volatility, negative political/macro shocks in Brazil, which accounts for about 25% of the emerging high-yield, high supply volume from China, a big drop in commodity prices and geopolitical tensions.

Excess spreads low

Emerging market high-yield spreads are currently 409 bps in aggregate but not as expensive as they look, according to the BofA Merrill Lynch report.

“Our own credit-loss estimates for the next 12-months on an index level are around 120 bps, or about 2% default rate times 40% recovery value. The difference between the overall spread and expected credit losses (excess spread) is therefore 289 bps, which is lower than the historical median of 575 bps,” according to the report.

The excess spread is lower than historical levels, but not necessarily unjustified. On the contrary, looking at historical drivers of excess spread suggest that EM HY spreads are actually 65 bps to 70 bps cheap compared to fair value.

Going forward, EM HY excess spreads are expected to depend on the trajectory of central bank asset purchases, cross-asset volatility and fund flows.

Making choices

“A key risk for spreads is a policy mistake by the U.S. Federal Reserve or the European Central Bank, which could lead to more volatile moves in U.S. Treasury yields and fund flows,” Hope told Prospect News.

One way to combat the risks is by careful selection of regional and individual credits. For 2018, BofA Merrill Lynch is overweight Latin America corporate credit, market weight for EEMEA and underweight emerging Asia.

“We expect country selection to be very important given idiosyncratic country stories and geopolitical risks,” Hope said. “We are starting the year with overweight stance on Brazil, Argentina, Colombia, South Africa, the Ukraine and Kazakhstan; and underweight United Arab Emirates, Qatar, Saudi Arabia, Malaysia, Singapore and Thailand.”

Meanwhile, Morgan Stanley suggests avoiding Brazil and Oman, due to fiscal concerns, Sri Lanka, due to its weak external position, and Peru, due to its rich valuation. Instead it recommends positioning in the long end across numerous curves, with some rotation into still challenged but cheaper credits including South Africa, Qatar and Bahrain.

Caution ahead

A myriad other variables are at play when it comes to these expectations. Among the biggest questions outstanding that could influence 2018’s outcomes are what happens with Venezuela, which has coupons overdue for more than half a dozen bonds, how China plans to change its credit allocation system, what happens in geopolitical hotspots like North Korea and the Middle East, and questions regarding whether certain countries such as Nigeria will be able to service its debt.

South Africa bond funds saw a $10 million outflow in the second week of December, according to EPFR Global, and EEMEA credit is in the crosshairs of investor focus as the ruling African National Congress party made deputy president Cyril Ramaphosa its new leader on Dec. 18, replacing current president Jacob Zuma. Ramaphosa is viewed as positive for South African assets, but the vote count proceeded despite accusations of vote rigging and other irregularities. ANC responded to the allegations by disqualifying almost 500 delegates.

Venezuela default questions

Venezuela and Petroleos de Venezuela SA bond prices gyrated in the past year on everything from news of violent street protests to evidence of tampering in a national constituent assembly election to president Nicolas Maduro’s proclamation in October that he wants to restructure the national debt. Bond prices plummeted to new lows and technical defaults on certain bonds occurred.

“It’s a mess, but it’s not melting down so that everyone is going to start selling EM,” a New York-based market source said.

More than 120 Venezuelans died in violent street protests against the government this past year. The protests began in February and by May there had been 50 days of marches. Moves to rewrite the National Constitution and dissolve the democratically elected National Assembly fueled the protests. And despite a national election in which 7.5 million Venezuelans voted against a new Constituent Assembly, this new body was installed in August.

After resolving in April that the constitutional order in Venezuela had been altered, the Organization of American States said it would not recognize rules implemented by the new assembly. On July 19, OAS secretary general Luis Almagro Lemes told a panel of the U.S. Senate Committee on Foreign Relations that Venezuela had collapsed into a dictatorship and that it was the responsibility of the international community to stand with the people of Venezuela. He said targeted sanctions that hold criminals responsible for the crisis had been helpful.

Despite these pressures, including new rounds of U.S. sanctions, the Maduro regime has managed to consolidate power and talk of regime change has faded.

The main question of 2018 remains the same as it was in 2017: is Venezuela willing and able to make its coupon payments? There are many uncertainties about what happens next, and some investors accelerated credit default swap contracts on four of the bonds. But the general consensus is that it is in investors’ best interest to wait and see.

“Everyone is in coupon-waiting mode,” Stifel analyst Victor Fu told Prospect News. “It’s case by case, bond by bond. And it looks like Maduro’s chances of winning a second term have increased after local elections, and the government will try for reelection in 2018.”

Oil outlook a question

Financing the debt increases the likelihood of Maduro’s success in such an election. But there is another big determining factor, and that is whether Venezuela will continue pumping oil that is needed for revenue stream to fund the payments.

Venezuela’s recent purge of the oil sector, which included firing and jailing people at the helm of PDVSA on corruption charges, could significantly impact the country’s ability to produce oil, Stifel’s Fu says.

“An army general is in charge of the oil sector and oil sector technocrats and veterans are out. This could reduce production dramatically,” he said.

“Maduro said a few weeks ago that PDVSA would be raising production by 1 million barrels, but I see the contrary is possible, and if oil production decreases significantly, that could accelerate the timing of a potential voluntary default,” Fu said.

Sanctions bite

Venezuela is in a technical default, claiming that some of the lacking coupons have been paid, but because of U.S. sanctions payments have been bogged down by intermediaries seeking to comply with the sanction restrictions.

The sanctions have not only crimped the nation’s ability to pay but they have made it tricky to make interbank transactions.

According to Venezuela, the coupon on its 7¾% notes due 2019 has been paid, but bondholders had not received the approximately $100 million due on the $2.5 billion issue as of Dec. 18.

Meanwhile, payments on some of PDVSA’s coupons have been received. On Dec. 15, transfers were completed on coupons for PDVSA’s 2021, 2024, 2026 and 2031 bonds; and on or around Dec. 18, bondholders received coupons on the PDVSA 2027, 2017 and 2020 notes.

“This has created a market perception that the government may be prioritizing payments on PDVSA’s bonds over the sovereign’s,” Fu said.

A default with Maduro as the nation’s leader would be the worst-case scenario for debt holders, a New York-based analyst told Prospect News.

Venezuela has about $70 billion of international debt, including $36.7 billion of sovereign bonds and $32 billion of PDVSA bonds, and not including loans, Fu said.

At times during the year there had been “hyper focus on [Venezuela and PDVSA] since nobody wants to be long into the weekend,” a New York-based trader said.

On Dec. 12, Venezuela’s credit derivative trades on its $2.5 billion of 7¾% notes due 2019 and $2.5 billion of 8¼% notes due 2024 were settled at auction for a final price of 24.5. And on Dec. 13, PDVSA credit derivative trades were also settled at auction bringing a final price of 17.625 on its $3 billion of 5 3/8% notes due 2027 and $6.15 billion of 8½% senior notes due 2017.

Colombia has own struggles

As yet there has been no real contagion to other markets, sources say. Venezuela is pretty isolated, a market source said. But he added, one country that may feel the effects of the Maduro dictatorship is the country’s neighbor Colombia.

“Colombia is going to feel it if people start selling and people start crossing the border in waves. Colombia won’t be able to handle a million crossing the border; it has its own problems, including reintegrating 15,000 guerrilla fighters, a ratings agency downgrade and possibly accelerated selling ahead of national elections,” the market source said.

A second market source noted that the border between Venezuela and Colombia is not an open border and that few would be able to pass through.

Full calendar of elections

The calendar of presidential elections is another key element in the equation for investment outcomes for 2018. Important elections to watch are those for Russia in March, Colombia in May, Mexico in July, Malaysia in August and Brazil in October. Expectations leading into and the outcomes of these elections will drive investor sentiment, sources said.

In addition to the political risk tied to elections, wildcards are North Korea tensions, the Iran nuclear deal, Saudi-Iran tensions, and the conflict among Gulf Cooperation countries, as well as U.S. sanctions against Russia and Venezuela and potentially others. All of these will be important to watch for their direct and indirect impacts on EM countries.

Some of these factors will affect hard and local currency bonds differently. For example, Venezuela contributes only to the hard currency index. Brazil, Mexico, South Africa and Turkey, which will all see important but very uncertain events, contribute 35% in the local index and represent only 15% in the hard currency index.

Oil’s meander

Oil prices moved all over the place in November as investors were beginning to square their portfolios for the year, and views on where oil prices are going in 2018 are mixed.

Goldman Sachs Group Inc. has one of the most bullish outlooks, boosting its oil price target to $62 per barrel for Brent crude from its old forecast of $58 per barrel on expectations that Organization of the Petroleum Exporting Countries and partners are motivated to maintain current curbs on production.

JPMorgan Chase & Co. is also positive, lifting its Brent 2018 forecast to $60 per barrel from $58 per barrel. UBS and Credit Suisse also raised their forecasts. But prices could soften if OPEC and other major producers don’t maintain current production cuts beyond March. And Citigroup Inc. left its new forecast for 2018 unchanged at $54 per barrel.

The producers currently have a deal under which they are cutting supply by about 1.8 million barrels per day in an effort to boost prices. Meanwhile OPEC itself has pointed to a meeting in June that could present an opportunity to adjust the agreement based on market conditions.

Local currency bonds eyed

There are more fundamental factors supportive of local currency bonds than hard-currency ones, according to Morgan Stanley Research, which views local markets as the next frontier for EM in terms of positioning and valuations.

The firm likes local currency bonds because recent flows into EM debt have been concentrated in hard currency bonds. Flows into local debt remain well below the peak reached before the taper tantrum in 2016, while flows into hard currency bonds remain well above it. If the U.S. dollar trends down in 2018, local currency bonds “still have decent room to grow,” according to the Morgan Stanley outlook report.

In addition, “real yields are high, meaning that as inflation troughs there is still no need for EM central banks to embark on a hiking cycle,” Morgan Stanley said. In this regard, Morgan Stanley prefers the region of Central & Eastern Europe, Middle East and Africa, or CEEMEA, over Latin America and the Asia emerging markets.

The bank also likes Russia and India and dislikes China, Mexico and Korea. In its outlook report, it said that South Africa, Turkey and Brazil could provide significant alpha opportunities but “the timing will be key.”

Since 2003, local and hard currency bonds have tracked each other closely, with a big exception being 2008-2009, when hard currency bonds underperformed significantly. The foreign exchange portion of investments has been responsible for the main difference in returns, causing hard currency bonds to outperform every year since 2011.

In 2018, Morgan Stanley favors local currency over hard given the potential for positive contributions from foreign exchange.

That being said, correlations between hard and local currency yields can be as high as 90% during times of sharp moves up or down in yields. But in times of sideways yield movements, it can fall to 50%, making foreign exchange less of a factor and idiosyncratic drivers more so. Morgan Stanley thinks 2018 will be more of a sideways year in terms of yields.

Sweet spots

Volatility in 2017 was historically low, the U.S. dollar was weak, rate hikes were well telegraphed benefiting EM currencies and hence EM debt, and the commodity and oil cycles were more or less in a range.

It was a veritable sweet spot and a recipe particularly favorable for Latin America’s credits. Their economies have strengthened, and they can now withstand higher U.S. rates. They are more resilient with built in cushion in reserves and economics that can tolerate a lot of pain, market sources said. A new question mark on the horizon is how the new U.S. tax program could alter the equation, and whether it will cause the U.S. dollar to strengthen.

In the meantime, the current sweet spots of investments look to be in BB emerging market credits like Mexico Brazil, Argentina, Turkey, parts of Asia, Indonesia and the Philippines.

The forecast for Brazilian gross domestic product is 3% for 2018 and improving credit fundamentals, BBB and BB credits are still cheap compared with regional and global peers. But political uncertainty around 2018 elections is a key risk, market sources say.

Meanwhile, Brazilian corporates performed very well over the last year and a half, driven by improving credit fundamentals and the gradual macro recovery. The ICE BofA Merrill Lynch Brazil index (EBRZ) showed an estimated total return of 12.4% in 2017. “We think that there is still juice left in the rally as BBB (209 bps) and BB (288 bps) spreads are still +30-35 bps wider than peers and most companies are on a positive trajectory,” BofA Merrill Lynch says.

Petroleo Brasileiro SA accounts for a third of the ICE BofA Merrill Lynch Brazil index, and BofA Merrill Lynch remains overweight on parts of the curve given the company’s positive momentum and recent improvements.

Rio Oil Finance Trust remains one of BofA Merrill Lynch’s top picks given pick-up in crude oil production and higher oil prices. The bank also likes various names in the metals and mining sector, including Gerdau SA and Companhia Siderurgica Nacional, but are more cautious on the protein sector.

Risks to this call are a rise in sovereign credit risks, lower commodity prices and a weaker Brazilian real. The key macro risks to 3% GDP for Brazil are fiscal and political. The primary fiscal deficit is expected to remain high at minus 2.3% in 2018, and government debt to GDP is still rising. An approval of the social security reform is instrumental in arresting the debt rise and preventing further sovereign downgrades, but this could be difficult to achieve in the near term, especially given the upcoming election that could flip control of the political agenda.

All three rating agencies have a negative outlook on Brazil (Ba2/BB/BB), and a downgrade could impact the eight remaining IG issuers the most. Those firms include Gerdau, Vale SA, Raizen Energia SA, Globo Comunicacao e Participacoes SA, Fibria Celulose SA, Embraer SA, BRF SA and Braskem SA.

The median five-year corporate issuer is trading at a spread of 65 bps over sovereign. Given the positive trajectory of the corporates and uncertainty around the sovereign's fiscal dynamics, BofA Merrill Lynch thinks it makes sense to be in corporates. But the October 2018 elections will be important to gauge the likelihood of future economic reforms and political stability.

Elsewhere, Ukraine corporate bonds were a good place to invest in 2017 with total returns coming in at an impressive 22%, according to BofA Merrill Lynch research. Several companies of the emerging European country completed restructurings and issued new bonds. The country is also restructuring and has an improving macro story with GDP expected to pick up to 3.5% in 2018 from an estimated 2.1% in 2017.

Among positive 2017 new deals were Kiev-based agribusiness Kernel Holding SA’s $500 million 8¾% five-year notes that priced at 99.5, and poultry producer MHP SA’s $500 million of 7¾% notes due 2024 that priced at par.

The single B credits tend to be tighter than their peers, driven mainly by MHP, which has tight spreads and strong fundamentals. BofA Merrill Lynch thinks Ukraine is a good country to be in for 2018 given the macro trajectory and attractive yields. It has an overweight stance on Ukraine corporates for 2018, and likes the new MHP 2024 notes, which came 400 bps inside the sovereign when it priced in early 2017, in particular.

Nevertheless, there is concern that the sovereign toes the line when it comes to its stance with the International Monetary Fund, on which it is reliant to refinance sovereign and sovereign-guaranteed debt in 2018 to 2020.

The Ukraine central bank warned Dec. 19 that failure to cooperate with the IMF represents one of the biggest risks to financial stability and that talks to launch a new program of cooperation with the IMF should start before the current one ends in early 2019. Cooperation includes committing to pension reform efforts and following IMF conditions on gas tariffs.

Currently the slowing reform push is expected to delay further IMF tranches until the second quarter and may hamper a pickup in growth.

Strong inflows in EM funds

Emerging market bond funds experienced net redemptions in the second week of December ahead of the U.S. Federal Reserve’s third rate hike for 2017, EPFR Global reported.

There was an outflow of $311.52 million for all dedicated emerging markets bonds funds, including those devoted to the dollar-denominated trade and those with local currency bonds. But this outflow represents only the fourth time this year that an outflow occurred, and this last outflow was a big improvement on the $1.17 billion net outflow for the week before the Fed’s last meeting of 2016 on Dec. 14, 2016.

“It wasn’t very dramatic,” EPFR’s Cameron Brandt said of December’s outflow.

The other outflows of 2017 included a $373 million outflow in the fourth week of January, a $79 million outflow in the second week of August and a $118 million outflow in the second week of November.

The outflows seemed to be tied to concerns related to U.S. interest rates, Brandt said.

Added together, the year’s outflows totaled $881.52 million, which was a mere pittance compared to a net inflow of $76.9 billion.

The four outflows can be linked for the most part to “anticipation of a move in U.S. interest rates,” said EPFR’s Brandt, but “the intensity of concern keeps ratcheting downward.”

Given that many market players are not around over the New Year, and will have to leave things in auto pilot mode, it’s understandable that they would pull back a little, Brandt said of investors’ action in December.

Nevertheless, almost every bond fund group struggled to attract fresh money, including high yield and all regions. China bond funds posted consecutive weekly outflows in excess of $100 million for the first time in more than two years, and some wonder if the latest outflow will be the start of a crack in the foundation of the emerging market rally that has been building on synchronized global growth, recovery of commodity markets and other factors.

“2018 will be a year of key transitions, with inflation rising and monetary policy tightening, while important parts of the global economy, namely China and the United States, are expected to see growth moderating.” – Morgan Stanley strategists in report published Nov. 28

“We expect country selection to be very important given idiosyncratic country stories and geopolitical risks.” – BofA Merrill Lynch’s Kay C. Hope, director of corporate credit research for Emerging Europe Middle East and Africa

© 2015 Prospect News.
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