CalPERS interview: part of the Investing in Fixed Income North America 2016 Report.
Interviewer:
- David Grana, Head of North American Media, Clear Path Analysis
Interviewees:
- Mike Rosborough, Senior Portfolio Manager, Global Fixed Income, CalPERS
- Scott Grimberg, Investment Manager, CalPERS
David Grana: What’s been the story with emerging market debt over the last six to nine months?
Mike Rosborough: If you think of this time as the continuation of the post 2013 cycle, what we have seen in the last 6-9 months was fairly Brazil-centric in terms of where the focus of the credit markets were. And a lot of this was political, although driven also by the fact that Brazil has been enduring a very long, deep recession due to a post-election phenomenon.
We have moved through several phases here as first we had the hit to oil credits, which started after 2014 as oil fell. Up to 2013, things were fine, with the focus more globally on what was going on in the Eurozone, specifically the Eurozone periphery. This captured the attention of the markets from 2010 – early 2013 with emerging markets (EM) being off the radar screen.
Everything seemed fine as China had done its post-financial crisis stimulus and so EM emerged from the strains of the financial crisis earlier than some of the developed countries and looked relatively unscathed when you consider what happened in the U.S and then the Eurozone.
We did, however, begin to see a turn in the commodity cycle, which doesn't affect all EM, but a significant number of ones, particularly on the debt side (i.e. issuers like Latin America or the resource-based issuers like Russia).
That pressure became apparent in the oil markets, starting in the middle of 2014 and going through to the end of the year. By the end of the year, Russia began to stumble, the Rouble began to fall and Russian credit spreads blew out.
This was the first event that took people’s focus more fully away from what was going on in the Eurozone and what happened to the developed markets (DM) during the financial crisis, back to the EM. Since we had been so caught up in these other events, we had turned our attention away from the EM.
David: What’s behind the bounce in EM bonds that we saw in May? Is it a recent phenomenon, or is there something deeper?
Mike: I would say that the recovery in the EM goes back to 2002. After Argentina defaulted, that was the end of the negative EM cycle that began in 1994 with Mexico's near default and devaluation, along with the Asian financial crisis, which was the negative end of the cycle in the EM. That set the tone in terms of valuation, positive reform and behaviors out of EM countries that began in 2002.
Things then began to turn more positive. And as commodities grew, EM did better. Although 2008 oil prices peaked, other metals carried on doing well, the cycle continued and EMs looked like darlings going through the financial crisis as there was less leverage. They had gone through reforms and in terms of the broader, global cycle, commodity prices held in there for a long period of time and at levels well above where the cycle started in 2002.
The tail winds lasted for a very long time and they only began to ebb in 2013 when there were developments like shale production, which brought oil on stream at much lower prices. These were the elements that began to upset the EM rally that was, on the debt side, a commodities focused rally. That is what we have been dealing with since the middle of 2014.
Russia and Brazil deal in oil and iron ore as their key commodities. The terms of trade shock has been reverberating through EM for the better part of 2+ years. The question is whether the worst of the commodity shock is over. And since the bottom of the oil prices that occurred in mid-February, we have turned more positive on commodities.
I would venture to say that we still see headwinds in oil as we get up towards the high 50s, as that is when shale production becomes economic again, rig counts probably go up and the financing of shale exploration kicks back in. There was certainly a nice recovery from the mid 30's prices up to the $50 that you have now and this has back-stopped a better environment for EM.
Some of the things that are encouraging, were the policy response of countries with trade issues, such as letting their currencies go, rather than trying to fight it and deplete their foreign exchange reserves. They didn't let their financial systems get into the trouble, and they would have if they had let their foreign exchange reserves go down. The banks would have gotten exposed the moment they devalued, because they would have allowed debt to build and reserves to deplete in defense of their currencies.
There was a change in behaviour after the 1997 and 1998' problems in EM, when people realized the perils of fixed exchange rates. And this continued with Argentina's break from the peg. To those who were willing to devalue aggressively so that they didn't have to drain reserves - and reserves were much bigger as a percentage of GDP going into this crisis - could have fought the battle longer if they wanted to, but they wisely accepted the terms of trade shock and devalued their currencies and dealt with the inflationary consequences.
David: Is the narrative behind desirable emerging market bonds about country or more so about specific industry and corporate exposure?
Mike: Key countries in EM: Brazil, Russia, Mexico, Turkey and South Africa, and the other larger issuers in terms of debt both in local markets as well as in dollar debt, realized and responded prudently to the terms of trade shock by allowing their currencies to adjust. They endured recessions of varying duration, they also endured the inflation that came with the currency devaluations.
Russia has fought this reasonably successfully. Not just through rates policies but also through income policies because they put a cap on civil service salaries, which enforced some discipline in private sector salaries.
Brazil had a tougher time, but it was in the process of allowing its administrative prices to rise, which they should have allowed to happen sooner. It just exacerbated their inflation problem and why they have kept rates high.
Mexico got through it more unscathed as their trade was primarily with the U.S and the U.S was recovering nicely in autos and similar items that Mexico manufactures and sells to the U.S market. And so, they were on a very good run from 2011 onwards. The auto cycle has been very strong and production has moved from elsewhere in North America, increasingly towards Mexico. Mexico also did its reforms to the oil industry, which was positive.
Where we are now is that we may have seen the nadir in commodity prices and are well off the bottom in terms of oil. Base metals, copper, iron ore may all have more downside, but the base that we are looking for is beginning to set stability in EM. The impetus to reform that comes out of these shocks and a repricing on the exchange rate side on the price of credit on the local interest rate side, makes EM a more attractive proposition than it was in 2013.
David: At what stage in the commodity cycle might we see this? Will it be when oil gets up to about 60?
Mike: No, it would have to go higher than that, as there is too much incentive to produce. This goes back to the fiscal issues I mentioned. Fiscal balance is still tied to $100 oil in some parts of the Gulf and so that has to rationalize first. There is not an excess yet, but still a deficit. So from a credit perspective, as long as we realize that there is a fiscal deficit driven by oil being where it is, relative to where its fiscal target is required for balance, that is something that requires rationalization, because it is not the basis for sustainable debt metrics.
Scott: There are a number of countries who would do great under $75 oil, but the problem is that if you took the pressure off of some of these countries, they need to do a lot of rationalization and reconciliation. And if you gave them relief now, it would delay the rationalization, so they would just have this problem in 2 years time with oil. If you look at the countries who have reacted to the low oil price, they were in vastly better shape than they were 2-3 years ago, so they will start collecting a bounty from these high oil prices.
David: Do you think we’ll see a return to the glory days of 2006 to 2013 anytime soon?
Mike Rosborough: In terms of whether we are getting back to the glory days of 2006-2013 my feeling is that we are still a couple of years away.
Scott Grimberg: I would be very skeptical of a return to the glory days if for no other reason than the growth differentials that dominated that period were heavily in EM favour and that has gone away.
Even though we have seen a stabilization in growth in EM we don't expect this growth to accelerate away from the DM space and this is the big difference between the stabilization and the golden years.
The big difference between this crisis and the previous crisis is that there is no balance of payment crisis. In other words, the EM countries simply had better policies and they structurally were in better shape to weather this downturn.
When we now examine whether there is a balance of payment crisis that we have to worry about, the answer is no.
People can argue about China, but in the EMs that we look at, we don't see the balance of payment crisis. We see a narrowing of the growth differential, which we think is finally stabilized and should support the coupon.
EM is better value than it has been in a long time because the combination of stabilizing metrics and better outlooks for growth is a good combination for clipping coupons.
David: What would be a motivation for investors to risk credit exposure to EM fixed income today?
Mike: In a broader sense, if you think of where the world’s fixed income rates are with U.S treasuries touching historic lows, Japanese and others being negative etc. in terms of a world that is starved for yield, EM certainly looks more attractive in this context and this is what has supported it. At the margin, would someone consider putting money into EM? Probably more so now than a year ago.
Scott: When you look at these countries and you see the 10-12% interest rates, you ask yourself where these have to go. They could fluctuate, but they are probably going to go down over the next few years.