Mike Rosborough, Senior Portfolio Manager, Investment Director, Global Fixed Income, and Scott Grimberg, Investment Manager, Fixed Income at CalPERS for the Investing in Emerging Markets, North America 2017 Report. Here's what they had to say...
David Grana, Head of North American Media, Clear Path Analysis: What’s the lay of the land of the fixed income market at the moment?
Mike Rosborough: Around June of 2016, we reached all-time lows in 10-year yields, at around 160 basis points (bps). Today, we are in a reasonable range from 180 to 275 bps. Credit spreads are tight, although not the tightest that they have been, across emerging market, high yield and corporate sectors. There is clearly a continuing reach for yield.
One of the changes that we’ve seen this year is that the Fed is starting the unwinding of its balance sheet. This could be significant for the fixed income market, but it is too early to tell. Volatility in the bond market, much like with the equity market, has been reasonably compressed this year. On a global scale, we have seen extensions of quantitative easing (QE) in the Eurozone and yield curve control in Japan, which has led to a muted trading range.
The greatest significance in the market is in the compression of yield spreads. This means that fixed income investors are still starved for yield globally and is unlikely to change soon.
David: The emerging markets seem to be making a comeback in spite of geopolitical tensions. What’s been the driver behind that?
Scott Grimberg: You aren’t seeing a surge in growth in most emerging economies. You are seeing improvement, but they are not growing at an average of 6-8%, as we’ve seen in the past. What you are seeing is stabilization for most countries, and Russia and Brazil emerging from recession.
What they have been doing right across these economies, barring some exceptions, is driving down their domestic inflation rates. Inflation was a big issue in the years from 2012-2015, and it has turned the corner in countries like Brazil, Russia, etc. With inflation falling, central banks have been able to reduce domestic interest rates, supporting credit growth and demand.
There has also been an impressive turnaround in external metrics. Since the EM downturn, external metrics, such as trade and current account balances, have improved for almost all of the economies in the space. This includes economies that were hit very hard, such as Russia. As an example, that economy’s current account deficit has been completely erased. Even Brazil, whose current account deficit got to 6% of GDP a couple of years ago, is now closer to balanced.
All of these factors have led to improvements in the sector.
David: Has part of this decline in imports been a result of a very strong U.S dollar?
Scott: Yes, but only to a certain extent. There is a push/pull there, but most of the decline in imports was due to domestic recessions and a sharp decline in domestic consumer demand. As internal demand slowed, exports declined as well, just not to the same extent. Brazil and Russia slipped into a deep recession, and growth rates from Mexico and emerging Asia uniformly slowed down. The exceptions seem to be Indonesia and Central and Eastern Europe.
As exports have been recovering, consumer demand remains soft, which has allowed for improved trade balances and, by extension, current account balances.
David: Commodity prices are at extreme lows and many of these countries have these as their biggest exports. What is the short and medium-term impact of this?
Scott: There are two factors. First are the oil dependent economies, such as the Gulf Cooperation Council countries. They are struggling with problems in their fiscal structures and, to a lesser extent, their external balances, so that their inherent credit quality, owing to their enormous financial resources, is being challenged.
Other oil exporters, such as Russia, have had such a dramatic internal adjustment that they can absorb declines in oil prices. This is because they have experienced large-scale depreciation of their currencies in the 2 years leading into 2016, largely following declines in commodity prices. They have basically adjusted to this lower external price. Countries who have not been able to adjust to the fixed exchange rate revisions, or because they have extremely sticky fiscal dynamics, are under more stress.
Some countries, such as Mexico and Russia, have done more than others to adjust to commodity prices, mostly through internal economic diversification and a decrease in their domestic credit structures. But there are others that are still in the process of doing so.
David: Some recent research has suggested that lower-rated countries are increasing sales of their debt. Are you seeing this, and does this concern you?
Scott: There has been a lot of index and ETF flow in the retail and institutional sectors. There has driven a lot of buying across curves, because these countries have relatively high interest rates. These investors will buy both higher and lower rated credits and, as the benchmarks are, for the most part, cap weighted, the more debt a country issues, the larger share of the benchmark it becomes.
I do, however, believe that some countries’ debts are undervalued, while others are overvalued. Even a country with deteriorating metrics can, for a while, stand against the tide and do well on inflows. However, when push comes to shove, when markets are not so buoyant, you will begin to see differentiation between the performance of indices and active managers that are carefully managing credit risk and exposure. This is where the improving metric countries and declining metric countries will become more evident.
David: Up to this stage, geopolitics has not made a dent in the fixed income market. Will this continue, or is there a possibility that there may be bumps ahead?
Scott: If you talk about large events that change risk appetite, such as Brexit and the U.S. elections, we have seen these as one-time moves without follow-through. What really matters is what happens when policies start getting implemented. You cannot dismiss the potential of grand scale changes in the policy of the directions of these markets. For example, China going to the WTO was a big event, but it took years for it to actually have an impact. The same may happen with Brexit. Investors seem to have accepted the idea that the immediate impact is limited. What matters more is the long-term impact.
Mike: The reason we haven’t had significant upsets, such as during the Asian Financial Crisis, is that there are more shock absorbers in place today. There are more countries with floating exchange rate, which have the option to use significantly large foreign exchange reserve balances to smooth and guide any changes in the exchange rate.
The fact that these shock absorbers exist in the system means that some of these issues pass through without creating stress on banks or other financial actors in a significant way. As a result, we have not seen the sudden stops in capital flows that caused crises of the past. This is a testament to the maturing of the financial system.
What has been significant for our EM portfolios is the on-going reductions in credit ratings of some major countries. This has caused some of those countries to be dropped out of some of our indices over the past couple of years. And yet, spreads and yields have been remarkably well behaved. Some may say this is a function of the rating agencies being behind the curve or because there is a reach for yield going on. That’s not to say that this attitude among investors will continue, but we seem to be getting conditioned to the fact that if we sell a credit on these events, someone will step in and buy it.
David: Are investment behaviors and patterns that were common in the past becoming less prevalent?
Mike: You have significant savings economies which are putting their capital into the world financial system, along with major central banks around with huge balance sheets, which are arguably suppressing yields. These sources of funds into fixed income markets didn’t exist when I started managing portfolios. This explains the current level of yields. As a pension fund, there is nothing more that we would like than to see a big run up in real yield, but with the amount of capital in the market, the spikes and declines of the past seem to be less common.
Take a look at some of our upcoming reports.