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Fixed-Income Insights

When the politics, economics, and finances are right, active managers can spot potential opportunities in “next-generation” emerging markets.

I recently traveled to Washington, D.C., to meet with the representatives of countries that have been paying Western investors (including Lord Abbett) hefty double-digit yields, while they try to turn around their economies after considerable instability.  

While these meetings coincided with the International Monetary Fund (IMF)/World Bank semiannual meetings, I was especially interested in scoping out any unforeseen risks to the current foreign-exchange regimes in Egypt and Nigeria.  

These countries are not necessarily in our emerging market benchmark indexes, but there are times when the individual investment stories from such emerging markets appear compelling enough to accept the risks of political upheaval, currency devaluation, or foreign-exchange restrictions that can accompany investing in these less-developed markets (or what J.P. Morgan categorizes as “next-generation” markets). As I told Reuters in a recent article on frontier-market investing, the improving global economy has offered a more positive setting for some of these stories.

Invest Like an Egyptian
Egypt, the largest Arab country and a major, albeit diminished, player in Middle Eastern politics, has made considerable strides since a military coup in 2013. Then, in November 2016, the government scrapped currency controls, and later undertook a painful devaluation of the Egyptian pound, which made the currency one of the cheapest of all emerging-market and African currencies, according to Bloomberg.   

The Egyptian government also took steps to reengage with investors, opening up a specific window to facilitate currency transactions. Further, it obtained financial assistance from the IMF for an economic-reform program to restore macroeconomic stability and return Egypt to strong and sustainable growth, in the hope that a cheaper currency would help spur exports. The IMF and the government officials agree that the program is off to a good start and that the fiscal deficit is on path to fall gradually, but consistently, over the next five years.

Yes, Egypt still has many problems. It needs, for example, to expand urban areas to contend with the country's rapid population growth rate and improve the nation's infrastructure. Inflation is still above 30% year over year, primarily due to the impact of the currency devaluation last year, the effects of which should wane over the next several months. But at the beginning of 2017, investors could get 21% on a short-term bill from the Egyptian treasury. While yields have dropped a bit since then, they’re still above 18%, and the Egyptian pound has remained stable. While the central bank is no longer directly intervening in the foreign currency market, it is being careful to prevent a whipsaw in foreign portfolio flows from significantly affecting the currency.   

Return to Nigeria
In 2016, Nigeria, the most populous country in Africa, was battling Islamic extremists in the north,   separatists in the center of the country, pipeline saboteurs in the south—all amid declining prices for the country’s oil, the source of more than 70% of the government’s revenue, according to The New York Times.

Instead of devaluing its currency, the naira, the government imposed massive currency controls, which meant investors had challenges to getting their money out of the country.2  

Early this year, the government was faced with continued recession and a shortage of foreign currency hampering all business activity, so it resorted to implementing a new window to facilitate foreign-exchange transactions by investors and exporters (called the “I&E window”). The U.S. dollar/Nigerian naira exchange rate at this window was set almost 20% higher than the official exchange rate (an increase in the exchange rate means a depreciation). This new window has provided liquidity for foreign investors to be able to access the local currency debt and equity markets again.  

Now that oil prices have rebounded and stabilized, Nigeria appears to be in better fiscal shape. Growth turned positive last quarter, but solely due to the mining sector. The government has been working with the IMF on additional reforms in return for financial assistance; but on October 10, the IMF cited policy implementation, foreign-exchange market segmentation, and banking system fragilities as major threats to sustained economic growth in Nigeria.3

In my meeting with the IMF team covering Nigeria, the team members sounded more constructive, in the belief that some of the measures Nigeria has implemented will start bearing fruit. Expenditures have been kept under control—perhaps too much, since the government is having problems executing necessary spending—but revenues are woefully inadequate, with tax revenues comprising only 6% of gross domestic product. As inflation comes down next year, local interest rates should be able to be cut, which should help bring down the very high interest expenses. In addition, Nigeria is looking to take advantage of positive investor sentiment and issue U.S. dollar-denominated debt at a much lower rate than what local currency investors are currently being paid.

The Bottom Line
Egypt and Nigeria illustrate the types of risk/reward scenarios that keep active managers, traders, and analysts in close touch in emerging markets local currency and U.S. dollar-denominated debt strategies. As described in a previous article on investing in Russia, we tend to be constructive on stories in which a country has gone through a crisis and emerged with external support from the IMF or the World Bank to undertake needed reforms, while paying investors a good yield to participate.

Of course, a positive macro backdrop helps guide such decisions—ideally a combination of good global growth, improving sentiment toward emerging markets, stable commodity prices, and increased foreign investment. With those ingredients in place, we can look at how former geopolitical hotspots are doing, and then invest in the good stories.

Liquidity is actually fairly good—as long as the global backdrop remains supportive. And with well-developed banking systems and a large number of local investors in Egypt and Nigeria, savvy Western investors don’t appear to have any concerns about selling bonds or Treasury bills in those countries out of their portfolios. The main risk is the currency. For example, if the Nigerian economy faltered and the government again slapped on capital controls, foreign investors likely would leave the market for a long time.

The last time Nigeria closed its foreign-exchange window was in 2014, but we saw signs that that might happen. If the specter of currency controls reappeared, the big question on investors’ minds would be whether yields of 18–19% would be enough to compensate them for that risk.

 

1  Dion Rabouin, “EM Fund Managers Move to More Exotic Currencies as Dollar Hits Lows,” Reuters, October 5, 2017.
2  Chris Stein, “Currency Controls force Nigerian Manufacturers to Buy Locally, Financial Times, November 27, 2016.
3
Emeka Anaeto and Babajide Komolafe, “IMF Highlights Threats to Nigeria’s Economic Growth,” vanguardngr.com, October 10, 2017.

 

This article is being provided for informational purposes only and is intended to illustrate certain information analyzed during the research process. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity,interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. Investing in international denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.

No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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