Outlook 2019: Mild, positive EM returns, flattish spreads expected in 2019 despite headwinds

By Rebecca Melvin

New York, Dec. 31 – Emerging markets debt enters 2019 at its weakest level of 2018, with the lighter-volume, pre-holiday trading of the Dec. 17-21 week leaving the asset class in even worse shape than a month earlier when many outlook reports were published.

The week’s rout occurred amid large losses for U.S. equities, which saw the Nasdaq stock market drop into bear market territory.

“If you look at [credit default swaps] today, there has been a dramatic movement over the last month, with big swings in sovereign CDS. Argentina debt is at the widest spread in the last month. I don’t know how the large swathe of PMs will deal with this exactly,” a New York-based emerging markets fixed income strategist said regarding portfolio managers and Argentina on the day before Christmas week.

Many have tried to get portfolio neutral on Argentina, which has seen its government debt as a percentage of GDP surge to 82% in 2018 from 52.5% in 2017, according to BNP Paribas’ data.

Among the sovereign’s debt load is a mega-$9 billion issue of notes priced Jan. 5, 2018. Before that, Argentina wowed the market by getting done a $2.75 billion “century” bond in June 2017, which is an issue many watch as a benchmark for the credit.

“The Argentine bond market has fallen back down to almost its lows. In the minds of EM portfolio managers, a cloud hangs over Argentine assets,” the New York strategist said.

Since January 2018, when EM debt in general went roaring into the year, fading optimism has led to an inexorable slide for Argentina, with only a couple of modest reprieves during the year such as in the late August-September timeframe when it bounced 11% related to its renegotiated IMF bailout. That agreement increased the amount of near-dated disbursements and adjusted certain fiscal and monetary policy requirements.

Meanwhile, most agree that the key risks for EM debt overall include: a market standing at the end of the credit cycle, global growth that is slowing, trade tensions and foreign exchange risks that are high, U.S. rates that are moving higher – albeit at a slower pace likely compared to expectations a month ago – and possible deterioration of U.S. corporate credit quality.

Modest 2019 returns eyed

Despite these risks, most predict modest improvement for EM debt in 2019, following a tough 2018 that was worse than lackluster. Total return for EM sovereign bonds in 2018 was negative 4.51% as of Dec. 20, when the spread stood at 425 basis points, according to the JPMorgan U.S. dollar-denominated emerging markets sovereign bond index, or EMBI global.

For 2019, EM debt returns are seen in the low-single digits, with sovereign spreads by year-end essentially unchanged at 425 bps, according to JPMorgan’s 2019 Global Outlook.

“Given a weaker starting point from 2018 and a potential reprieve at the start of 2019, we see full-year EM fixed income returns in the low single digits and underperforming USD cash, with local markets returns of +1.1%, EM sovereign returns of +0.2% on 50 bps of spread widening to 425 bps by end 2019, and EM corporate returns of +1.5% on 50 bps of spread widening to 375 bps by end 2019. Our EM fixed income recommendations going into 2019 are MW EM FX, EM sovereigns, and corporates and small UW rates as a low-yield UW duration view,” according to J.P. Morgan Securities’ research team in the report published Dec. 13.

The team wrote, “We had cut UW EM positions in early November’s weakness, leaving us more neutral as we see a reprieve in the next few months with global growth forecast to rotate, EM spreads at year wides, and upcoming U.S.-China talks a wild card.”

Likewise, BNP Paribas sees EM debt “looking resilient” as a whole, with the space more able to weather storms than in the past, as “on average, the countries’ inflation is lower, current account imbalances smaller and foreign reserves higher, while their debt composition is now mostly domestic.”

BNP Paribas’ Marcelo Carvalho, head of global emerging markets research, and Gabriel Gersztein, global head of emerging markets strategy, said that that slower growth in advanced economies and less supportive international financial conditions will create a challenging environment, but not “a disaster” either from the financial or commercial channels.

Carvalho and Gersztein wrote that the China yuan is something to watch closely as it is viewed as a proxy for gauging potential threats to EM.

“If, as we expect, the Chinese authorities refrain from massively weakening their currency to boost growth, EMs should remain supported,” the research and strategy specialists wrote in Global Outlook: Synchronized Slowdown, published on Nov. 28.

Meanwhile, BofA Merrill Lynch’s corporate credit research team sees debt for emerging markets high-yield credits returning positive by 5.7% for 2019 and the return for investment-grade corporates returning 3.9% for the year, with spreads remaining stable in most countries.

Countries starting from a wider base in terms of spread should see tightening, including Argentina, Brazil, Indonesia and South Africa, the BofA Merrill Lynch corporate credit team wrote in its report, 2019 – the year ahead: Hiking in EM – views from Baja to Beijing.

BofA Merrill Lynch’s baseline forecasts calls for IG spreads to tighten 4 bps to 177 bps and HY spreads to tighten 40 bps to 453 bps. Given the bank’s forecast of a U.S. 10-year Treasury rate of 3.25%, it expects total EM corporate bond return of 4.4% for 2019.

By region, the bank predicts total return of 6.4% for Latin America, 4.8% return for Emerging Europe, Middle East and Africa and 3.1% return for Asia.

Risks for EM debt

The end of synchronized global growth, a continuation of rising rates in the United States and worries about the impasse in China-U.S. trade talks are some of the most referenced risks to EM debt.

Specifically, a sudden rise in U.S. inflation, which would force rates higher than expected, and longer-than-expected U.S. dollar strength, and a meaningful deterioration of corporate credit-quality in the U.S. would likely reduce flows into emerging markets debt and hurt the space.

Nevertheless, BNP’s Carvalho and Gersztein point to the fact that the crises of EM in the 21st century have been much more muted than the crises of the 1980s and 1990s. Those were meltdowns that devastated the space, but the sovereign debt crises since 2000 have been contained and much less significant.

2019 elections

Among idiosyncratic risks is another crowded election calendar with local elections in Turkey on March 31, a presidential election in Indonesia on April 17, general elections in India in April and May, European Parliament elections impacting Czech Republic, Hungary and Poland on May 23-26, and general elections for South Africa in May, Argentina on Oct. 27 and Poland in November or sooner, according to BNP Paribas’ data.

Of these, the most significant election to watch is Argentina’s. Its result will be a key to assessing any continuity in the generally market-friendly policies of president Mauricio Macri. Some believe that Macri’s re-election prospects are strong after political corruption charges against Cristina Fernandez de Kirchner, Macri’s strongest opponent, hit the tape last fall. But there is still room for doubt as Argentina’s economy teeters.

“The center-right administration of Macri has favored market liberalization, diminishing distortions across the economy and reducing fiscal imbalances. If a domestic recession brings the left-wing Peronists back to power, markets might worry about the potential for derailing the policy trajectory and clouding the reform outlook,” BNP’s Carvalho and Gersztein wrote.

The expectation of policy change is not as significant, but still a moderate for Indonesia, India and South Africa, the BNP analysts said.

In Indonesia, the re-election campaign of incumbent president Joko Widodo is likely to pit him against the more nationalistic Prabowo Subianto. Widodo won in 2014 with a relatively narrow margin of 53% and has pursued significant reforms, BNP’s Carvalho and Gersztein wrote.

In India, polls suggest prime minister Narendra Modi’s BJP party will lose its majority. Controversial policies have eroded Modi’s popularity, but his broader alliance is expected to retain power.

In South Africa, investors will watch how strong a mandate the ruling ANC will get. BNP’s analysts believe a “stable showing” of close to 60% would support president Cyril Ramaphosa and his structural economic reforms. A result closer to 50% might leave Ramaphosa vulnerable, and less likely, but possible is that a rise in support for the far left EFF causes the ANC to lose its parliamentary majority, leading to a more populist coalition.

But the policy change risks are limited in Turkey, Czech Republic and Poland.

The local polls in Turkey might be more significant than usual as a barometer for president Recep Tayyip Erdogan’s polices, especially in key cities such as Istanbul. But the current administration’s political position and approval ratings are strong, BNP’s Carvalho and Gersztein wrote.

A New York-based emerging markets fixed income strategist underscored Erdogan’s position, citing the leader in his description of the comeback of Turkish debt this fall.

Turkey’s Erdogan, despite “playing a very weak hand,” has managed very well, he said, noting a change in his fortunes as it relates to the United States. U.S. tariffs of Turkish imports were removed after American pastor Andrew Brunson was returned the United States following months of pressure regarding Brunson’s imprisonment in Turkey on terrorist charges since 2016.

In addition to Brunson, the invasion of Syria, its support of Qatar and the buying military hardware hurt Turkey’s relations with the United States.

Argentina, Turkey diverge

The cash bonds of both Turkey and Argentina suffered nearly identical plights during 2018 up until August, when Turkey was able to mount a recovery while Argentina slumped further.

In August, both Argentina and Turkey cash bonds were down about 20% for the year. But for the last three months to Dec. 21, cash bond returns for Argentina’s dollar-denominated debt remained minus 8.1%, while cash bond returns for Turkey’s dollar-denominated debt was up 6.2%.

“It’s the tale of two recoveries. And Argentina was the one that got the IMF package, which usually encourages capital inflows,” the strategist said.

The economies of both Turkey and Argentina slowed in 2018, the currencies crashed and both government’s raised interest rates.

The bonds of both Turkey and Argentina were falling all year and came to a bottom on Aug. 13. At that time, Argentina cash bonds were down 22.6% and Turkey was down 20.6%.

But the correction in Turkey was much greater. From Aug. 13 to Sept. 21, Argentina advanced 11.2% but then came to a stop and fell from there. But Turkey rebounded and kept going.

Besides Erdogan’s improved position, other factors in the turnaround were Turkey’s diversified economy, which is more industrial and responsive that Argentina’s, with a strong export market.

The trade balance of Turkey in U.S. dollar as of Dec. 17 was negative $500 million compared to a trade account that was negative $6 billion on July 21, the strategist said.

Furthermore, the country has “very strong support from the investor base,” the strategist said, with “large participation by offshore Turkish investors that supported the bond market.”

On the other hand, growth in debt by Argentina so soon after settling with bondholders from its last default was seen as hurting sentiment, as was the concern that the IMF is ensuring external debt payments only through 2019 and the country faces a large repayment schedule in 2020.

Mexico, Brazil post elections

2018 elections have changed the political and economic landscape in Latin America. The victory of Jair Bolsonaro in Brazil’s presidential election means more weight tilting toward much-needed social security reform in that nation; and in Mexico, with the new leadership of president Andres Manuel Lopez Obrador means a decidedly stronger social agenda and socialistic policies.

In response, Brazil has had an increase in allocations and there is a “sell” now in place by many banks for Mexico.

After investors took a wait-and-see approach following Lopez Obrador’s victory in July, they dumped Mexican assets in reaction to the president elect’s announcement in October that he did not plan to complete the Mexico City airport for which $6 billion of bonds in four series had already been issued.

The fortunes of Mexico’s assets improved after the new government, which was installed in December, made the Airport bonds one of its first items of business. It announced a tender for about 30% of the bonds on Dec. 3.

On a recent session, Mexico City Airport’s 5½% bonds due 2047 were around 82.75, which was up from about 74.85 before the tender news.

The tender was amended in response to bondholder objections and demands that the government guarantee payments on outstanding notes and use passenger fees from other airports as collateral. The tender offer was also increased to par from the original offer asking holders for submission of the four different series of notes through a modified Dutch auction for $900 to $1,000 for every $1,000 in principal.

Some saw the negotiations as positive, others thought it was unnecessarily acrimonious, and opinion on Mexico remains divided. One source compares Lopez Obrador to South Africa’s leader. “Both are highly political animals and they have very urgent agendas,” the source said.

The agenda of South Africa’s Ramaphosa is black prosperity, the source said. And with the one-term presidency of Lopez Obrador, or AMLO as he is known, in Mexico, “he has a very urgent, purposeful and large social agenda.”

The AMLO budget unveiled in mid-December did strike a “textbook,” 1% budget surplus that cheered some investors, the source said. But subsequent actions, like using the military for development of an alternative airport, cutting out the private sector, resurrected worries.

The Mexico City airport cancelation “is an example of the willingness to use the national balance sheet without regard to rating agencies and sovereign credit metrics,” the source said.

“He’ll take a negative outlook or a half notch downgrade” to further the agenda, he said of Lopez Obrador.

Nevertheless, Mexico has been a market performer so far. The spread on Mexico’s 2047 sovereign bonds had widened 3 bps to 47 bps by the middle of December, compared to the sovereign IG index, which had widened by 4 bps.

Rates risk

Financial markets were on Fed watch in December when the U.S. Federal Open Market Committee raised the central bank’s target rate by 0.25% for the fourth time in 2018. But it signaled that it expects a slower pace of tightening in 2019.

The FOMC raised its Federal Funds rate to 2¼% to 2½% but new projections showed more officials expect the Fed will need to raise rates no more than two times next year. Eleven out of 17 officials expect the Fed will need to raise rates no more than twice, compared to seven out of 16 officials in September.

Six officials expect the Fed will need to raise rates three times or more, down from nine officials in September, and six officials believe the Fed may need to raise rates no more than once, up from three officials in September.

The FOMC press release following its last two-day policy meeting of the year referred to “further gradual increases.”

The shift comes after several months of market volatility that has seen a 20% slide in the Nasdaq stock market and a 40% drop in oil since October.

Ahead of the December FOMC update, a source questioned whether the market was expecting too much from the Fed. “It seems like the market expects too much. Presumably, it’s going to make some changes, a New York-based market source said of the central bank, “But [the market] may be pricing in a lot more dovish mood than it should.”

Fed futures have been getting progressively more optimistic as people get more downbeat about the economy, the source said.

“Originally the Fed messaged for three rate hikes in 2019, but now the market is not pricing in any hikes for 2019,” the source said.

CEEMEA’s prospects

The Central & Eastern Europe Middle East and Africa region benefits from the strongest credit metrics within the emerging markets.

The region’s gross leverage is 2.3 times and interest coverage is 9.0 times, leading to higher spreads per turn of leverage across most rating buckets, except for A rated where more highly leveraged Middle East sovereign-owned entities dominate, according to BofA Merrill Lynch credit research.

Regional growth is expected to be stable at 2.2% and the inclusion of the Gulf Cooperation Council credits in the JPM EMBI index should help valuations. “We expect United Arab Emirates and Saudi Arabia to benefit the most,” BofA Merrill Lynch credit research said.

Ukraine was a top performing country in the CEEMEA in 2018 and it is expected to put in a positive performance in 2019. South Africa looks attractive at current levels, the research team said, although it recognized high risk here, while Turkey will likely have another volatile year, with Turkish financials expected to suffer the most.

China’s onshore credit effect

China's deleveraging process started in late 2016, and since then the growth of China's onshore credit bond market has slowed.

The market came to a virtual standstill in May-June when a jump in onshore defaults led to heightened risk aversion. But after a cocktail of loosening measures was announced, including reserve requirement ratio (RRR) cuts, looser implementation of the asset management guidelines and the medium-term lending facility (MLF) tweak to encourage buying of lower-rated bonds, the market has recovered with a meaningful monthly net supply of credit bonds.

BofA Merrill Lynch’s China economist expects the Chinese government will roll out more policy easing measures on both the monetary and fiscal front to cushion the negative shock from the looming trade threats.

“We think the Chinese regulator’s policies, which will likely maintain a moderate liquidity and low interest rate in onshore market, will support the Chinese onshore credit bond market performance,” BofA Merrill Lynch’s Asian credit team wrote in a report on Asian credit entitled, 2019: A year of two halves.

The ultimate recovery of the onshore credit bond market should help to alleviate offshore supply and refinancing concerns for Chinese corporates. On one hand, the report, dated Nov. 21, said the diverging outlook for China's onshore and offshore credit bond market in the near-term should help the relative value of the offshore market to increase further, which should allure a gradual come-back of the China bid to the offshore market.

“That said, risks appetite for lower-rated bonds remained low given the continuous increasing default rate, and net supply of non-AAA bonds remained very limited, suggesting limited access to onshore bond market by high yield issuers,” BofA Merrill Lynch’s Asian credit team, Joyce Liang, Irene Sun, CFA, Kok Onn Yong, CFA, Lefu Li, CFA, Sharon Chang and Sirius Chan, wrote.

The team recommends staying defensive going into 2019, with preference to investment grade over high yield and focusing on short-dated carry opportunities such as BBB sovereign-owned entitles, and quality and short-dated high-yield property sector credits.

Potential total returns are predicted to be plus 3.2% for investment grade and plus 6.3% for high yield.

China-U.S. trade wild card

Trade relations between the United States and China are expected to result in a challenging environment for EM corporates in 2019.

BofA Merrill Lynch said China (in addition to Mexico) will be a key country to focus on regarding the trade war and refinancing in China.

The upcoming U.S.-China talks are a wild card, said JPMorgan’s Luis Organes and Jonny Goulden, when surveying the EM outlook.

Over time, however, signs of pain from the trade war should grow.

After U.S. farmers protest against the tariffs and stock market correction, consumers will soon complain about higher prices. These points of pain will likely motivate a deal early next year.

Both sides will probably roll back some of the tariffs that have been put in place, while China might agree to more imports, potentially some commitment to trade deficit reduction and more protection on intellectual property.

A bear-case scenario will be across-the-board bilateral tariffs. However, if this occurs, the mutual pain would be so acute that it would probably not last long. In the base case scenario, ultimate impact on Asian economic growth is moderate and even more limited impact on Asian credit fundamentals.

That said, risk sentiment could be weak in the near-term as JPMorgan expects further escalation of trade tension before a deal could be reached early next year.

JPMorgan forecasts 50 bps spread widening in the Corporate Emerging Markets Broad Bond index, or CEMBI Broad, to 375 bps with a 1.5% return for the year.

“We are of the view that EM corporates can hold up better against the macro headwinds given the conservative behavior in recent years of focusing on deleveraging while limiting capex/M&A activities, which put them in a stronger starting position,” said JPMorgan’s Yang-Myung Hong.

Global credit eyes headwinds

EM debt isn’t the only asset class facing the onslaught of 2019’s headwinds.

“The current market zeitgeist seems to be that credit markets are the weak link in the global risk markets chain and are set to break down and destroy value in a way not seen since the dark days of 2008 through early 2009,” according to JPMorgan.

Based on the bank’s projections, returns across global credit markets will range from small negative single digits to small positive single digits. This does not seem especially attractive relative to the return on cash, money market instruments, or other short-duration instruments.

“The three consensus views seem to have become even more entrenched now and include that spreads will widen, that BBBs are the problem and that U.S. high yield is the most expensive part of the global credit complex.

Spreads have widened materially over the past month against the backdrop of broad weakness in global risk markets. But from current levels, 2019 may close very near to the present.

Risks to the baseline forecasts for 2018 showed up in a big way in higher market volatility, a drop in commodity prices, concerns about China and U.S.-China trade. Mexico went bad, as did the Ukraine. About the only thing that went right is that there were no negative political/macro shocks in Brazil.

JPMorgan said tightening global liquidity and macro headwinds make it challenging for spreads to compress heading into 2019, noting a neutral stance and defensive bias. Overall, the bank favors investment grade but recommends specific high-yield segments or countries where valuations have adjusted or positive momentum exists.

JPMorgan has a small overweight bias in Asia focusing on BBB and BB, corporate hybrids and select China high-yield property credits.

Within CEEMEA, the bank is overweight the Middle East through GCC investment-grade credits, but underweight emerging Europe due to the still cautious view on Turkey banks and reduction in Ukraine corporates.

For Latin America, “we are overall neutral as we look for the short-term positive momentum in Brazil to remain in place for now. But limited value in the rest of the region.”

There are more favorable micro level trends, but the resilience of the asset class is likely to be tested on both the fundamental and technical side by macro headwinds.

Defensive trading strategies

The general investment themes for 2019 are “steady cash flow and earnings on the long side plus selective bets like gold mining in the case of a weak dollar, and cyclical, short side bets,” a New York-based strategist said.

“Hold as much as possible a high-quality portfolio,” the strategist said.

In that vein, this strategist favors pharma, utilities and telecom, including the likes of Indonesian state-owned electric utility Perusahaan Listrik Negara, which has seen its bonds like its 2027 notes tick up in December. He also likes Brazil’s Fibria Celulose SA, which is a low-cost pulp and paper producer merging with fellow pulp and paper company and compatriot Suzano Papel e Celulose SA.

While paper is traditionally cyclical, it seems these companies are closer to being a diversified or conglomerate, the strategist said.

The strategist also likes Russia’s PJSC PhosAgro, which priced $500 million 3.949% 5.25-year senior loan participation notes in January 2018 and which is a big supplier in Europe with decent credit metrics.

Telecom in central America and renewable power in India are also good bets, he says. He is also a buyer of Brazilian beef and gold mining in Russia.

Due to low oil prices, some of the credits he would be short on include Middle East real estate and mall operators. He is a seller of Dubai’s DP World Ltd., which priced four tranches in 2018 including a 10-year dollar-denominated sukuk, or Islamic bond, a dollar 30-year note, a euro-denominated eight-year note and a sterling-denominated 12-year note.

But Koc Holding AS, an Istanbul-based industrial conglomerate that priced $750 million 5¼% seven-year notes in March, is a high-yield credit that may deserve a second look, he said.

In terms of sovereigns, he wouldn’t be a buyer of South Africa, Ukraine or Argentina.

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