EM credit-strong foundations and 2018 outlook

EM credit-strong foundations and 2018 outlook

Over the past months, I have continued to stress the importance of holding an allocation to Emerging Markets (EM), as I strongly believe that selective sovereign issuers, in addition to corporate issuers, pose attractive opportunities for returns.

My perception is not based on the short-term view preposition of investors exploiting the herding effect, whereby individuals follow a larger group of market participants, rationally or irrationally, but on the strong foundations that selective EM countries hold as opposed to their developed peers.

As opposed to 10 years ago, EM economies now represent a significant share of global GDP. In this regard, the importance of synchronisation amongst regions should have its relevant share given the fact that over the years we have seen an expansion from all fronts.

In fact, historically, EM corporate issuers were primarily associated with natural resources, however nowadays following the expansion and growth of some key EM economies, we are seeing issuance from other industries too.

In contrast to what most investors believe, the increase in EM issuance does not imply a lower credit quality. In fact, when digging into the numbers, to the surprise of many, EM credit both at Investment and High yield grade, tend to have less leverage (defined as debt divided by earnings before interest, tax, depreciation and amortisation), when compared to developed peers.

Through experience, many corporate issues unfortunately, despite holding very strong credit metrics, are negatively conditioned by the sovereign rating, which holds a company from being upgraded. However, spread differentials are still visible.

In fact, looking at data compiled by Bank of America Merrill Lynch Global Research as at the end of August 2017, EM investment grade offer a spread differential to a US comparable peer of 0.26%, whereas when compared to US High Yield the differential is that of circa 0.38%. Selectively such spread differential is unjustified and one should exploit these discrepancies to beef-up returns.

Looking into 2018, the global growth synchronisation is one of the positives for the EM world. Growth in developed regions will spillover positivity over the EM countries.

One other important element is for those EM countries, which are still very conditioned in terms of growth by the energy sector. Indeed, the recent rally in oil prices (circa 40% gains from the lows touched in June 2017) gave oil oriented issuers a further opportunity to manage well both their capital expenditures and their capital structures.

In addition, in the latter’s case over the past year we have continued to see companies within the EM region strengthening their balance sheets by extending their debt maturities and re-financing at lower rates. This gives further comfort to investors that in 2018 credit risk and thus, default rates should be on the low side.

Reviewing the latest global growth forecasts by the International Monetary Fund (IMF), the overall macro backdrop looks benign and this should be a huge positive for EM.

Nonetheless, the credit remains sensitive to currency movements and yes, the expectations of further rate hikes in 2018 might cause some sort of volatility due to a stronger dollar.

That said, let’s not forget that a stronger dollar tends to reflect a wider global growth weakness. In this regard, the possible appreciation of the US dollar which can be triggered by both monetary tightening (possible rate hikes) and fiscal expansion (lower taxes and an increase in infrastructure) might be capped.

In conclusion, a benign macro environment, in addition to an increase in domestic demand will push EM credit towards more improving credit metrics.

Thus, the spread differentials selectively are indeed opportunities for investors to get hooked to higher yields with lower risks, as opposed to the illusion of many that EM are always riskier than the developed world.

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.


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