In Focus interview: emerging market debt

Increased volatility has hit the emerging market debt sector this year. Anton Dombrovsky (Senior Vice President and Product Strategist at PIMCO) talks to Ian Aylward (Head of Manager Selection at Barclays) to discuss key issues in the market, including the need to closely monitor elections and where his team sees opportunity.

IA: Anton, you work closely with Eve Tournier who manages the PIMCO Diversified Income Fund, which can invest across all areas of the credit markets, however, today I want to focus on an area that has gained a lot of media attention lately - emerging market debt (EMD).

Could you start by summarising what we’ve seen in EMD markets over the last couple of years?

AD: We entered 2018 on the back of indeed two very strong years for EMD and with a supportive external backdrop for emerging markets (EM): synchronized global growth, historically low volatility, in addition to healthier EM fundamentals and weaker US dollar. Rising oil prices were also positive for EM countries that are net exporters of the commodity.

As you’d expect, these conditions have been particularly supportive for risk assets such as the EMD asset class, which tends to come with a higher yield, reflecting the higher inherent risk. However default incidents have been quite rare and the perceived risk of such investments has reduced and so has brought about some welcomed capital appreciation in these risk assets.

IA: However, this year hasn’t been quite so plain sailing?

AD: No, indeed this year has been far more volatile and less directional for Emerging Markets, as this convergence with the US and other developed markets broke down.

A large contributor of this has been the divergence in monetary policy between developed markets, with the US on a more advanced rate-hike path.

As a result, we’ve seen a retrenchment of USD from oversees back to the US, mainly due to this central bank tightening. This has resulted in the strengthening of the US and relative weakening of EM currencies, which has created a headwind for certain EM regions.

This mainly took effect in Q2 this year, during which period local currency debt was down nearly 10% in dollar terms – one of the worst quarters in history of EM local debt. However drawdowns have been primarily concentrated on specific countries, primarily Brazil, Argentina and Turkey.

IA: Another aspect which you’re no doubt mindful of is the busy calendar of elections in emerging markets. In the last 12 months we’ve had elections in Russia, Mexico, Columbia, Indonesia, and of course we have Brazil and Thailand later in the year.

How does this tend to impact your thinking?

AD: Elections and political and policy risk in general have always been an important topic when investing in Emerging Markets. This is certainly something that the team pays close attention to, given the potential for spikes in volatility, like we have seen with recent elections in Mexico, Turkey and upcoming in Brazil.

Just as with the developed world it can sometimes be tricky to correctly position for a specific elections outcome, so the team at PIMCO focuses on the political dynamics in every country that they invest, by travelling there at least once a year, by speaking to key policy makers, politicians, opposition parties, etc, to understand the implications for different outcomes. This analysis is then used to assess the fair value of a country’s assets.

IA: Looking ahead, what’s your stance on the market over the next 12 months and where do you see the pockets of opportunity?

AD: Looking at the shorter term, we can see why EM has cheapened so far this year; there has been a great deal of volatility due to elections, de-synchronization of growth, strengthening dollar, etc. In fact the Diversified Income Fund is actually underweight Emerging Markets given the uncertainty around global trade, other exogenous and EM specific factors.

However, within this underweight allocation, we are selective in where we are positioned. We are overweight countries more isolated from US protectionism, such as India and Ukraine. We also like high quality countries such as selected issuers in the Middle East that carry well despite their relatively high quality. Looking at our underweight positions, we try to stay away from countries with a stretched balance sheet or fully priced valuations. These countries include Lebanon, Philippines and Malaysia.

IA: How about over the longer term, do you remain constructive on EMD?

AD: Short-term we are cautious on emerging markets given the uncertainty around more restrictive trade policies, monetary policy divergence and country specific developments. We are selective within the asset class and we continue to focus on countries with strong fundamentals and liquidity. And on a longer term basis, the team is constructive on emerging markets for several reasons.

Firstly, while we foresee the Fed continuing their pace of monetary normalisation, we believe in this notion of a “new neutral”, whereby interest rates will stabilize at a lower than historic level, which we think creates an attractive real rates advantage for emerging markets investors.

Also emerging markets in general are in an earlier stage of the business cycle than developed markets, meaning that they have more capacity for a strong growth.

And finally, valuations are relatively cheap when compared to developed markets, and so investors can find better returns for their risk if they know where to look.

PIMCO are one of the largest managers of fixed income in the world with around $1.8trn of assets under management. The Diversified Income Fund has been on the Barclays platform since 2011.

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