Global economic activity continued to deteriorate in the second half of 2011 due to near-term challenges facing both Europe and the U.S. Within emerging markets we continue to monitor macro challenges such as high inflation numbers, tightening liquidity conditions, the ongoing debate between a soft and hard landing in China, global commodity prices, and the still-elevated geopolitical risks in some Middle Eastern countries.
Yet emerging market (EM) sovereign and corporate bonds have been relatively strong in terms of credit fundamentals and balance sheets and this trend is forecasted to continue (See Figure 1 for sovereign debt-to-GDP ratios ). We believe the asset class appears well-positioned to navigate slower global growth in 2012.
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In this environment of challenging macro conditions but relatively strong fundamentals, understanding the macro linkages affecting emerging markets as well as identifying which names to invest in (within both the sovereign debt and high yield corporates universe) is extremely important, since credit quality cannot be decoupled from global events.
Considerations for emerging markets investors
We believe emerging markets investors should consider the following points in 2012:
- Credit fundamentals and relative value remain attractive – We believe EM high yield (HY) corporate fundamentals remain strong when compared to both historical levels and developed markets (DM). EM HY companies were able to delever after the 2008/2009 crisis due to improved cash flows, the introduction of leverage targets, disciplined capital expenditures, extensions of debt maturity profiles and greater liquidity (See Figures 2 and 3). And even though economic headwinds are strengthening and EM corporates are perhaps less likely to experience same-pace financial improvements in 2012, we believe the accumulated improvement in prior years puts EM HY corporates in a stronger position relative to many of their DM counterparts.
- Low refinancing risk – We believe refinancing risk should be low over the next two years due to record issuance over the past three years. Effectively, EM corporates used years 2010/2011, when the demand for EM debt and the issuance was strong, to prefinance their growth. Limited financing needs should provide technical support to the overall EM corporate market especially as we expect a continuation of the environment of increased volatility and recurring periods of risk aversion when the access to capital markets and the cost of raising capital may be challenging.
- Sound domestic market as a funding option – Generally speaking, the domestic EM bond markets are less mature than those of developed world and tend to be dominated by government bonds and, to a small extent, investment grade corporate credit. In an environment where lending conditions tighten in the international capital markets, the domestic markets may be a source of funding for EM HY corporates. EM countries with higher sovereign credit ratings tend to have a larger domestic corporate bond market. For example, Korea (A1/A/A+ Moody’s/S&P/Fitch) has a large domestic bond market – totaling approximately 116% of GDP according to estimates from BIS and JP Morgan as of November 2011 – composed of corporates, financials and government debt. This contrasts with Brazil and Mexico whose bond markets – at 75% and 40% of GDP, respectively, according to the Federal Reserve’s Flows of Funds data as of 3Q11 – are more focused on bonds issued by the government and financial companies. This compares to 250% of GDP in the U.S.
EM outlook
Although emerging markets high yield balance sheets are generally in good shape, as discussed, any deterioration in economic activity could cause lending standards to tighten and default rates to rise. Thus, it is very important to determine if current spreads are adequately capturing potential credit losses and liquidity concerns.
At the end of 2011, EM HY performance as measured by CEMBI Broad Diversified HY Index was -3.8%, incorporating the negative blowback of the global economy and scarcity of secondary market liquidity. EM HY corporates also underperformed their peers in the developed world (as shown by the broader emerging and developed market indexes in Figure 4). We see this as providing upside potential for the asset class in 2012. We believe the underperformance of the asset class can be explained by secondary market liquidity that has deteriorated (according to a report published by FINRA Trace and Bank of America in December 2011, corporate trading volumes are 50% below their historical average) and underperformance of the Chinese HY names such as the property developers that were pressured by the government’s measures to cool down the sector and the heavy new issuance in the industrial space.
We believe EM HY looks attractive on a relative basis, offering a 364 basis point pickup over U.S. HY, (see Figure 5 for index definitions and spread difference as of January 10, 2012). Both indexes used as proxies for these asset classes have an average credit quality of BB.
Further, we carefully analyze the sectors in which EM high yield companies operate, as well as their business models, in order to estimate any potential impact they might suffer should the developed market downturn accelerate. Likewise, this thorough analysis is equally important when we measure the potential impact of EM sovereigns suffering a downturn (e.g. a potential slowdown in China with a subsequent decline in commodity prices, hurting commodity-dependent countries). With corporate credit investment professionals located in North America, Asia and Europe, and with specialists focused on individual industries and regions, PIMCO is uniquely positioned to evaluate names that we believe have the potential to outperform in our anticipated base and tail scenarios. Our strong top-down approach complements PIMCO’s bottom-up industry/regional expertise.
Ultimately, we favor a higher-quality tilt and less cyclical sector exposure. In our opinion, emerging markets will likely remain captive to tail risks given a more uncertain macro backdrop but will also likely be supported by greater policy flexibility, low refinancing needs, stronger domestic balance sheets and continued positive economic growth. Many EM corporates appear to be relatively better prepared than their DM counterparts to navigate this uncertain outlook. In addition, historical correlations between overall emerging market corporates and developed market corporates are low, providing potential for portfolio diversification.