May and June were difficult months for fixed income assets. While virtually all parts of the market were affected, emerging markets debt was hit particularly hard, although prices have since begun to recover. Michael Gomez, a managing director and co-head of PIMCO’s emerging markets portfolio management team, discusses what caused the turbulence, where PIMCO has identified EM opportunities and why the firm remains bullish on the asset class.
Q: What caused the recent volatility in emerging markets?
Gomez: After several years of double-digit returns, emerging markets faced three major headwinds in the second quarter of 2013, all of which occurred simultaneously or in rapid succession. The first was the recognition that the U.S. economy was starting to deliver more robust growth, a notion that drew capital back to the U.S. and strengthened the dollar. While a strong U.S. economy is certainly good for emerging markets long term, in the shorter term these dynamics led to headwinds, first for EM currency and then for the markets overall.
The second drag was data confirming that Chinese growth was slowing. This wasn’t a surprise to many market watchers – and PIMCO’s forecast has been below consensus expectations for some time – but it raised the possibility of a hard landing, something we believe the country will be able to avoid. In our view, China is entering a necessary and more internally driven economic cycle, which implies lower, but ultimately more sustainable growth. Still, China’s challenges have knock-on effects for other emerging markets through trade and other economic linkages.
The third headwind was the unleashing of volatility from an unexpected source: the quantitative easing (QE) programs by developed market central banks. These programs, intended to suppress volatility and stimulate risk appetites, experienced a backlash of sorts. Hints of QE tapering by Federal Reserve Chairman Ben Bernanke sparked the volatility, which was then aggravated by Japan, where despite the implementation of “Abenomics,” government bond yields rose. After initially – and predictably – producing yen weakness and a stock market rally, currency strength and a Nikkei sell-off ensued; this forced the unwinding of large levered positions in turn, many of which involved emerging markets. These volatility-induced losses cascaded into further selling, setting off a downward spiral.
Q: Why was EM debt hit so hard?
Gomez: Rather than a single trigger, the acute response in emerging markets was caused by a confluence of several factors. Since 2010, the asset class has seen record inflows from foreign investors, pushing local nominal yields to historic lows and causing external spreads to tighten. At the same time, concerns grew over unrest in places like Turkey, Egypt, South Africa and Brazil. And finally, EM debt is a relatively small asset class, which means that the window to exit is narrower than the door to entry – in other words, liquidity can fade quickly amid market shocks. We saw this in May, when the loss of liquidity exacerbated the turbulence from the unwinding of those levered positions.
That said, EM outflows have been manageable and characterized mostly by tactical asset allocation moves. In reality, most investors remain underweight the asset class given its bearing in the world economy: emerging markets represent nearly half of global GDP, but roughly 15% of global fixed income markets.1 Many institutional investors have acknowledged these discrepancies and used the volatility as an opportunity to increase their EM exposures. It’s also important to put short-term declines in perspective: If you look at the nine individual months of 1.5 standard deviation declines in EM local debt2, you’ll see that in every case but one, returns over the following three months were positive. The one exception was September 2008, the depths of the financial crisis. We’re nowhere near those conditions now.
Q: How did developed world quantitative easing affect EM fixed income?
Gomez: The post-crisis QE programs implemented by developed market central banks – the Fed, European Central Bank, Bank of Japan and so on – were designed to inject liquidity into their respective economies. However, they also repressed yields and distorted valuations, exerting a gravitational pull across higher yielding global asset classes, including EM debt. As yields thinned in these economies, so did the buffers against potential hiccups. For example, at the end of 2012, Brazil’s dollar-denominated sovereign debt was yielding 1.8%, which was below the 2% U.S. inflation rate; in local debt, yields on 5-year Turkish bonds troughed at 5.5%, with inflation in that country at 8%. These artificially low returns were a direct consequence of the quantitative easing by less healthy developed economies.
Q: Do these moves reflect a sea change in emerging markets?
Gomez: Long term, PIMCO believes the EM debt proposition holds up extremely well. Many of these economies have balance sheets that are significantly less leveraged than their developed market counterparts, with ample dry powder and flexibility to maneuver in this environment. However, the global economy overall is attempting to deal with the breakdown of the debt-fueled, Bretton Woods model that had turbo-charged growth from the 1950s up until the Lehman crisis. Today, every country is trying to understand how to change their growth models and dynamics, and emerging countries are not immune to this challenge. Thus, it’s happening in the U.S., Japan and Europe, but also in China, Mexico, Brazil, South Africa and so on. Many EM governments are deploying reserves to smooth volatility as well as making policy adjustments. They recognize that pre-2008 dynamics will not be returning anytime soon, if ever. The Chinese government is tapping on the brakes of the local banking system in an effort to prudently deflate the buildup of excessive leverage. Monetary policy is heading in a more orthodox direction, toward higher nominal and real interest rates. There’s a realization that if the U.S. path is normalizing – and our thesis is that this is a longer-term proposition – then emerging markets will eventually have to make themselves more competitive in order to attract global capital.
Q: What has PIMCO been doing in this environment?
Gomez: We are continuously evaluating the economic and market environment, and then testing our investment priors in the asset class against perceived changes in the backdrop. We ask ourselves, are these changes fleeting or more permanent? If our priors hold up and valuations are compelling, we’ll look to add to our exposures. If they no longer hold up and the pricing no longer justifies the risk, then we’d look to sell. For example, we’ve been increasing our exposure to Brazil and Mexico local debt, but because we expect policy-driven volatility to continue, we’ve also trimmed certain exposures, moved to more senior positions in the capital structure and added duration, particularly “hard” duration – financing moves into external sovereign debt by moving out of corporates.
We believe some of these challenges will persist, with global asset returns likely to be more tempered in the period ahead than we’ve been conditioned to expect by the recent past. So, rather than the double-digit returns we saw through the end of 2012, we would expect EM assets over the next three to five years to produce returns in the mid to high single digits – still making them attractive relative to other global fixed income assets.
Q: Have valuations become more attractive since the sell-off?
Gomez: We certainly have seen a shift over the past 12 weeks. Valuations that we believe entered the period as rich now appear to be fair, while those that entered at fair are now cheap in many cases. We’re also seeing some improvement in relative compensation. For example, the yield on the 5-year dollar-denominated Brazilian debt I mentioned earlier has risen from 1.8% to 4.25%, or 150 basis points higher than its U.S. counterpart. There’s a general belief, including at PIMCO, that emerging countries, economies and markets will be increasingly important drivers of growth. However, we still need to be adequately compensated for higher levels of volatility, and while we’re beginning to see opportunities selectively, this is an environment that requires prudence and strong differentiation among assets.
Q: What is PIMCO’s view on Brazil and the impact of the country’s recent social unrest?
Gomez: Like other EM countries, Brazil’s policymakers are struggling to formulate a longer-term, more sustainable set of economic and financial policies. There’s a realization that the current situation is very different from the 2002 crisis, and that rather than waiting for external tailwinds, internal policy transitions must occur. The social unrest, sparked by anger over money being spent on the World Cup, reflects how badly those changes are needed. An increasingly robust middle class is demanding that government expenditures and fiscal priorities be reallocated and used more effectively. The country has to move forward, but it’s being restrained by an unhealthy mix of ineffective and loose fiscal policy on the one hand, and high government intervention in its capital and investment markets on the other. This mix has created distortions in other parts of the economy, resulting in tepid growth. Still, the economy remains on reasonably solid footing and the fundamentals are good, so we’re investing selectively. It’s important for investors to understand the country’s challenges, but also its path toward smart policy solutions, and then use that knowledge to evaluate how the risk and compensation are being priced.
Q: What is PIMCO’s approach to investing in EM debt?
Gomez: The opportunity set for EM debt has evolved dramatically, encompassing sovereign and corporate bonds issued in both hard and local currency; these assets have also become more liquid as more investors make EM a permanent part of their long-term strategic allocations. That breadth and availability provide informed investors like PIMCO with a wide range of options through which to express our views. Our investment process is well attuned to this highly differentiated asset class. Our top-down macroeconomic outlook and fundamental country assessments allow us to emphasize countries we believe will offer the most attractive risk-adjusted return potential, as well as to gauge the external susceptibilities arising from the increasing interdependencies of today’s global economic structure. Constant on-the-ground analysis and a strong risk management framework ensure consistency between our views and portfolio positioning, while also helping us take advantage of relative value opportunities. This level of intelligence demands significant resources. PIMCO’s emerging markets fixed income portfolio management team consists of 18 specialists based in four different PIMCO offices around the world, who are supported by the work of some 50 credit analysts and expertise of our regional portfolio committees. We also have tremendous depth of experience as a firm, navigating the complexities of the asset class. PIMCO began investing in emerging markets more than 15 years ago and today, our size and presence provide execution and other potential advantages, which we seek to translate into benefits that we can pass along to our clients in turn.
1 Source: International Monetary Fund (% of GDP); BofA Merrill Lynch, Bank for International Settlements (% of fixed income markets).
2 Data shown for the 10 years ended 30 June 2013; as measured by the JPMorgan GBI-EM Global Diversified Index.