Fundamentals matter again for emerging market investors

Just like other risky assets around the world, emerging market bond and equity prices have snapped back into shape since the huge crisis-fighting injection of liquidity from the US and eurozone central banks in March.

EM economies are likely to be hardest hit by the pandemic, but on aggregate, asset prices are close to the levels they held before the panic selling set in.

Look into the detail, however, and the recovery is somewhat uneven, with some analysts asking whether the full effect will last much longer.

“If you look at the fundamentals of many EMs and then look at the yields, you have to say something doesn’t add up,” said Claudio Irigoyen, economist and fixed-income strategist at Bank of America Securities. “For that to make sense, you have to add in that the [US Federal Reserve] and the European Central Bank are the buyers of last resort of all risky assets and [rely on] the perception that nothing can go wrong.”

Such an approach, he warned, may not end well. “Investors think they will unwind their positions before the trade blows up. It never works out that way.” 

To an extent, this is a mirror image of the same interminable debate being played out in other big stock markets, particularly in the US. There, the S&P 500 index has rocketed back to record highs, despite the poor health of corporate America and the grotesque concentration in the technology sector. Investors are left wondering whether something has to give.

But EMs face an extra dimension.

In the past, investors have been encouraged to overlook the weak fundamentals of many emerging economies by the ready money to be made in the carry trade — the practice of borrowing where yields are low, to invest where they are higher, said Win Thin, head of currency strategy at Brown Brothers Harriman.

Now, that carry has melted away. Interest rates have fallen in EMs along with those in developed economies. In Brazil, a classic carry-trade destination, the central bank cut its policy rate this month to an all-time low of 2 per cent — less than the annual rate of inflation. The policy rate has fallen 12.25 percentage points in less than four years, leaving precious little reward, if any, for investing in one of the biggest casualties of coronavirus.

As a result, the Brazilian real, along with other EM currencies, has failed to rally in line with stocks and bonds. That means “the good news is that fundamentals matter again”, Mr Thin wrote in a recent note. “The bad news is that there are a lot of EM countries with bad fundamentals.”

It is not only monetary policy that has moved to the extremes. The fiscal taps have been fully opened, with a corresponding expansion of debt. Brazil’s government debt was equal to 92 per cent of gross domestic product at the end of last year, according to the Institute of International Finance, already for many a worryingly high level. Analysts at Capital Economics warn that, without a sharp contraction in government spending in the coming years — something unlikely in the circumstances — it could balloon to almost 150 per cent of GDP over the coming decade.

Furthermore, EMs have never been so dependent on global rates staying at record low levels, said Mr Irigoyen. This leaves them particularly exposed to any pick-up in US growth.

“If interest rates start to rise on the expectation of a sharp recovery, that will put pressure on the rollover of debts that many EMs will have to deal with,” he said.  

The carry trade is not altogether dead. Siobhan Morden, head of Latin American fixed income strategy at Amherst Pierpont Securities, noted that investors had shown strong appetite for the bonds of speculative-grade governments such as El Salvador and Costa Rica, where yields were still in the high single digits.

“You can take the carry now but you have to know that they both have solvency problems that they need to fix next year, and both need an IMF programme,” she said.

Elsewhere in Latin America, willing investors are already scarce. Argentina and Ecuador, praised for reaching settlements with their creditors and restructuring unsustainable debts early in the crisis, have struggled to find buyers for their bonds. 

“People say it’s solved, they have restructured, so everything is fine, but they are not exiting their crises,” she said. “They still have to restructure their local debts, they still have to restructure loans from the IMF, they still have primary deficits of 6 to 8 per cent of GDP — they are still in the first phase of their crisis, bondholders are trapped long and there’s no yield.”

Argentina’s restructured bonds are priced at an implied yield of almost 12 per cent, she noted, but no coupon payments will be made for the next three years.

Fundamentals, she said, really do matter.

“It’s really hard at this juncture to identify the next big trade,” she said. “We had a nice rally, the appetite for carry has suppressed yields, but we will reach a time when you have to worry.”

jonathan.wheatley@ft.com