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Emerging Markets Relative Value Still Looks Attractive

20 December 2017 by Felipe Villarroel

Emerging Markets have had a terrific 2017. The hard currency CEMBI (Corporate EM bond index) will most likely end the year 8% in the green, while the EMBI (EM sovereigns) index will be even higher than that. Flows into the asset class (EM dedicated bond funds) have been consistently strong throughout most of the year and will total around $70 billion in 2017 (EPFR data). In EM corporate markets, we continued to see growing net issuance from Asia, while issuance from EMEA and Latam remained quite low, a trend that is expected to continue in 2018. As we end the year, performance momentum remains strong, with indices closing at 2017 highs, which contrasts with parts of the European and US High Yield markets, which have had weaker ends and will probably close below recent highs.

These positive developments leave valuations close to historic tights, a phrase that applies to a lot of asset classes around the world as we enter 2018. As asset allocators and strategic income managers though, a very important input is relative value across asset classes, and on this front EM hard currency corporates still offer decent value.

One of the metrics we look at when assessing relative value is the spread ratios and how these have changed through time. Particularly useful when spreads are tight, the simple quotient between say EUR BBB spreads to EM BBB spreads gives an insight on how much relative compensation investors are getting for the relative credit risk they are taking. We believe this metric is better than just looking at the simple spread differentials; for example, assuming the same rating, an asset class that gives you 100bps more spread at a time when the comparable benchmark is averaging 50bps is more attractive than when the benchmark spreads are at 200bps. We also stress that this is just an input in the investment process and it remains important to analyse these numbers in their historical context and not just in isolation.

The graph below shows the spread ratio of EM corps compared to EUR and US spreads for the same ratings. For example, the yellow line shows the ratio of EM corps Single B spreads to US Single B spreads. There are a couple of interesting observations we draw when looking at this data. The first one is that EM corps are not particularly stretched against DM corps when compared to this historic metric. It is interesting to note that even after what has been a very strong 2017, EM corps actually look more attractive now compared to EUR HY than at the start of the year, and valuations are at similar levels compared to US HY. Additionally, it is clear how expensive EUR IG credit has become during the year; as can be seen in the graph, the spread ratio between EM single As and BBBs and EUR single As and BBBs is now at levels last seen in 1999, when EM credit had cheapened due to the aftermath of the Asian and Russian crisis . On the other hand, compared to US IG indices, EM corps are within the historical range.

This analysis is also backed up by a number of factors. Firstly, the technical and momentum factors we mentioned earlier remain positive for EM as we enter 2018. Secondly, regarding fundamentals, a reasonable number of EM countries are still in the early stages in their economic cycles. Brazil and Russia, just to name a couple of examples, still have Central Banks that are loosening monetary policy, are seeing falling inflation, and actually not long ago they were experiencing negative YoY GDP growth. There are of course differences among countries within EM but as a general comment, the cycle looks younger in EM than in DM. This means that one can justify a smaller premium than in previous years for EM vs similarly rated DM corps.

So as a conclusion, although on an absolute basis EM corps look somewhat expensive, we continue to believe it offers good value on a relative basis for 2018 and think consequently with strong fundamentals this sector is one of the few that should tighten.

Data: Bloomberg and BOA ICE Indices

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