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Fixed-Income Insights

When it comes to investing in emerging market bonds and currencies, active managers know there will always be a lot of political risk in certain countries. The question is how much that risk affects the markets and underlying economies—and how to respond.

Leah Traub, Ph.D., may not have the weight of the world on her shoulders, but she certainly has weighed a lot of political risk managing Lord Abbett’s emerging markets currency and emerging markets local bond funds and supporting the firm’s currency-hedging strategies.

Name a volatile emerging market and she can pinpoint the investment strengths, weaknesses, opportunities, and threats in short order. Give her a half hour, and you’ll get trenchant takes on Thailand (military coup against caretaker government after a six-month crisis); Israel (Gaza war); Russia (Ukraine, sanctions, higher inflation, weak currency); Brazil (inflation, commodities slump, elections); India (new prime minister, renewed growth prospects); Indonesia (slowing growth, stagnant manufacturing, new president); China (slowing growth, deleveraging, structural reforms); and Turkey (nagging current account deficit1).  

No matter which hot spot is on the front burner, Traub’s team assesses how political risk affects a country’s economic underpinnings. Typical questions include: How strong is the country’s central bank?  Is it independent from whatever political turmoil might be unfolding at the time? If it is, can it intervene to support the local currency? “If the country needs structural or fiscal reform and doesn’t have an independent central bank, then the political risk becomes a much bigger deal for the currency and bond markets,” said Traub.

In the case of Thailand, it took a coup to restore stability to the markets, Traub added. As for Israel, while Lord Abbett owned some of its short-duration sovereign debt during the most recent Gaza war, the firm hedged out the currency risk. As the Israeli central bank responded to the impact of the war on the economy by cutting interest rates, the Emerging Markets Local Bond Fund benefited from both the bond overweight and the short position in the currency.

“Political risk just goes with the territory,” Traub said. “But Israel has the necessary institutions to keep the economy functioning even when they’re fighting an enemy so close to home.”

"Putin Risk"
Of course, Traub would look for some kind of premium for taking on political risks, especially in Russia, where markets have gyrated wildly this year.

“[President Vladimir] Putin is a risk in the sense that you never know what he's going to do,” said Traub. “Is he going to take over a company? Is he going to disrupt gas shipments to Europe? (We don’t think so.) Given such uncertainties, Russia always trades cheap relative to comparably rated sovereign debt because ‘Putin risk’ is highly embedded in their prices. So we are always going to want to receive a risk premium for investing in Russia.”

Commenting on various economic sanctions imposed against Russia, Traub said the most immediate impact has been higher inflation because the country can’t get goods that it needs, and when it can, prices have risen sharply. With higher inflation, the central bank has had to raise interest rates, which in turn has caused bond yields to remain high, but not enough to avert currency depreciation.

While some investors worry that Russia might impose capital controls to stem currency outflows, Traub believes that is very unlikely and that the central bank will eventually provide support for the ruble.

Brazil, India, and Indonesia at a Crossroads
In Brazil, the big question is whether the country can produce positive policies to reduce the country’s deep-seated inflation, address production bottlenecks, make the economy more efficient, and boost infrastructure investment.

“[Newly re-elected president Dilma Rousseff] knows she has to do something because the credit rating agencies are threatening to downgrade the government’s debt to junk, which would be very, very bad for Brazil,” said Traub. “She is not going to let that happen. So she has to tighten fiscal policy while allowing for more private investment. Whether she would do as much as a new leader would with a mandate for more change is another matter. Brazil needs sounder fiscal policy and structural reforms to improve its growth outlook.”

Faced with similar challenges, India encountered considerable volatility going into its elections earlier this year. But when the reform candidate Narendra Modi won, investor confidence improved. “There is no real economic impact yet, but there's a sense that this new prime minister has the right agenda and the political support needed to implement it,” Traub said. “There’s a sense that he is going to remove red tape surrounding infrastructure projects, reduce energy shortages, decrease corruption, improve the nation's external accounts, and attract more foreign investment.”

Indonesia, the world’s fourth most populous nation, had a similar dynamic after reform candidate Joko Widodo was elected president in July. But unlike India, where Modi’s Bharatiya Janata Party has a majority in parliament, Widodo may have a more difficult time pushing a reform agenda through the Indonesian legislature given the need to form a coalition with opposition parties.

While higher yields in Brazil, India, and Indonesia have attracted considerable foreign investment in recent years, Traub believes rising U.S. Treasury yields could force those countries to do more to maintain investor confidence. As Traub put it, “If the yield gap narrows, investors are likely to favor the United States given its better growth prospects than these three countries. But if those three can institute lasting structural reforms that will increase their potential growth, then that could be another way for them to gain assets via both foreign direct investment and portfolio investment, which is what they desperately need.”

Even so, Traub is less concerned about the impact of rising U.S. rates on emerging markets than last year’s so-called “taper tantrum,” when fears of Federal Reserve (“Fed”) tightening led to a big sell-off.  Those fears caught the market by surprise—but turned out to be premature.   

“If the Fed is removing accommodation in a backdrop of improving U.S. economic growth, that would be a positive,” Traub said. “What would concern me is Fed tightening even if U.S. growth starts to slow down. But the chances of that happening and roiling the markets seem rather slim because Fed action typically hinges on economic data. I think it would be much better for it to hike rates with 3% growth than 1.5% growth.” 

Unprecedented Divergence
Traub is struck by how much the policies of developed and emerging markets have diverged from one country to another. While the Fed and the Bank of England are generally expected to hike rates in the next six to nine months, the European Central Bank (ECB) is cutting rates (as a possible prelude to a quantitative-easing program of its own), and the Bank of Japan may have to enlarge its quantitative-easing program.

“The same dynamic has filtered into emerging markets,” said Traub. “Some are experiencing inflation and hiking rates; some are weathering disinflation (or outright deflation) and cutting rates—all of which can have a profound effect on asset prices in those countries.”

The common denominator is slowing growth, although the growth of emerging markets still outpaces that of the developed world. (See Chart 1.) But countries most dependent on China have been hard hit by the slowdown there, particularly major commodity producers that have experienced a sharp drop in prices. 

“Countries that hitched a ride on China’s growth machine generally fared well in the aftermath of the financial crisis in 2008–09,” Traub said. “Now it’s almost the reverse. Economies that are doing better are those that are more diversified and maintained significant exposure to the United States and other parts of the developed world.”

 

Chart 1. Emerging Markets Still Outpace the Developed World  
Emerging market economies and advanced economies’ GDP evolution of growth (% chg. y-o-y)

Source: IMF, World Economic Outlook, 2014.
For illustrative purposes only and does not reflect any specific Lord Abbett mutual fund or any particular investment.
Past performance is no guarantee of future results.
Gross domestic product (GDP) is the total value of all the goods and services produced within a country’s borders. When that figure is adjusted for inflation, it is called the real gross domestic product, and it’s generally used to measure the growth of the country’s economy.
Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Due to market volatility, the market may not perform in a similar manner in the future.
The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities markets in more developed countries.

 

Worried about a Commodities Downturn? 
Traub said she isn’t losing much sleep over the sharp drops in commodities prices this year. (See Chart 2.) After all, a number of producers built up supplies at the same time demand was falling, and as with past market cycles, it takes time to work out such imbalances. Clearly, lower prices would hurt major commodity exporters and countries that have not been able to diversify their economies away from commodities. But other countries would benefit.

“People forget that more than half of the emerging markets universe is comprised of commodity importers,” said Traub. “They’re not just exporters. They import a lot of commodities. One prime example is India, a huge commodity importer, which should benefit tremendously from lower commodity prices. So should Turkey, which hasn’t been able to implement any kind of structural reforms to control its current account deficit. All of a sudden, you have oil prices in the $80-$85 per-barrel range, as opposed to $110 earlier in the year [according to Bloomberg]. That big of a drop makes a significant difference for large oil importers.”   

What does concern Traub, however, is the risk that continued drops in commodity prices lead to a deflationary spiral, a cycle in which falling prices lead to spending reductions and declining economic activity. Much of that concern centers on Europe, where the ECB will be hard pressed to implement the kind of quantitative easing that has helped prop up the U.S. economy.

“It's not as simple for the ECB to do that,” said Traub. “They're going to struggle with implementing a large scale asset purchase program. They're not going to be able to be aggressive enough, and it's quite possible we will continue to see very, very low levels of inflation coming out of the eurozone.”

Could massive increases in infrastructure spending, as recommended by the International Monetary Fund, reverse that trend? One could argue that China tried that and it worked, for a while, and that the government is now dealing with the excesses by cutting back spending and implementing a variety of structural reforms to increase consumption.

In stark contrast, Malaysia had a grand infrastructure plan that was stuck on the drawing board for years. When the plan was finally implemented a couple of years ago, a more stable government ramped up spending, particularly on infrastructure. This increased spending meant importing a lot of materials, which in turn resulted in the falling current account surplus and a rising fiscal deficit.

“Some investors reacted negatively when they saw a decline in the trade surplus last year, even though all that infrastructure spending was for a good reason,” Traub recalled. “This year Malaysia’s current account surplus started to increase again. As growth continued to improve, the central bank eventually had to raise interest rates, which benefited the currency. All of which underscores the notion that some turnarounds in emerging nations can be a longer story, so the market has to be patient with that.” 

 

Chart 2. Energy Prices Have Led the Commodities Slump This Year
IMF Commodity Price indexes (2005=100)  

Source: International Monetary Fund.

 

The balance of payments is a record of a country's international transactions with the rest of the world. Transactions are organized in two different accounts: the current account and the capital and financial account. The current account includes all the transactions (other than those in financial items) that involve economic values and occur between resident and non-resident entities. 

 

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