10th June 2016
Jan Dehn, head of research at Ashmore, notes EM manufacturing is rising even as manufacturing in developed markets slumps – which is likely due to the effects of financial policies in developed economies. He also provides his outlook for EM FX reserves, which is brightening, thoughts on Petrobras’ progress and Oman becoming the 66th country in the JP Morgan EMBI GD index, and views on how the global market backdrop is changing, with markets shifting from a giant momentum trade to value investing. EM should be well-placed to perform well in this environment.
The global manufacturing cycle is in decline with one exception, Emerging Markets (EM)
EM manufacturing bottomed out in late summer 2015 and has since been on an upwards trend, while manufacturing in the US, the Eurozone and especially in Japan has been in decline over the same period. The net effect of rising EM PMIs and falling developed market PMIs has been to push down global manufacturing.
Why are EM manufacturers bucking the trend in manufacturing in developed markets? The answer probably has something to do with global financial policies. As investors have pulled money from local markets to chase QE-sponsored markets in the developed world, EM currencies have cheapened which has rendered EM producers more competitive (this is also supported by strong evidence of sharply improving EM external balances).
At the same time, policies have strongly favoured financial markets, while the neglect of fundamental reforms has gradually rendered the real economy more sluggish. In this environment, capital has been lured away from the real economy within developed markets towards financial investments. Re-investment rates of profits in companies in developed markets have been extremely low as companies have favoured buying back their own stock, even to the point of issuing debt in order to do so.
EM reserves are on the up
EM reserves are up 2.1% year to date (5.0% annualised), excluding China and Saudi Arabia. FX reserves in China and Saudi Arabia, while down year to date, are also declining at much reduced rates compared to last year. In fact, China’s reserves have risen slightly in the last two months. EM reserves have held up remarkably well in recent years. At USD 8.6trn, EM reserves are down a mere 2.3%, or USD 198bn, since the end of 2012. This means that EM central banks still control 78% of the world’s FX reserves, despite the near-perfect constellation of anti-EM shocks in recent years, including outflows caused by the Taper Tantrum, the start of the Fed hiking cycle, the Dollar rally and the commodity price crash. The resilience of EM reserves offers an important insight: there is very little risk that EM reserves will decline to levels that warrant serious concern. In fact, the risk is now that EM reserves go up rather than down.
Petrobras went shopping
Following its bond issue a fortnight ago Petrobras last week went shopping, buying back nearly USD 6bn of its own bonds. The buybacks targeted near-term maturities, reducing principal repayments by USD 3.4bn in 2017 and USD 2.5bn in 2018 and USD 65m in 2019. This means that overall amortisations have been reduced by more than one quarter in 2017 and 2018, significantly easing Petrobras’s refinancing challenges for the foreseeable future. Comments from Petrobras’ new CEO Pedro Parente about reforms at Petrobras, the stateowned oil giant, are highly encouraging. Parente says that the company will set fuel prices, sell assets and will operate independently of central government.
Oman joins JP Morgan’s EMBI GD benchmark index
Following its inaugural bond issue last week, the Sultanate of Oman looks set to become the 66th EM country to join JP Morgan’s EMBI GD benchmark index. The index is therefore on track to have 80 members by the end of the decade. The rapid rise in the number of countries issuing Dollar bonds compared to a decade ago when there were just 26 EM countries in the index is very important. The increase in the number of index members reflects the broad-based macroeconomic resilience, stronger growth, rapid financial deepening and broadening and more stable political conditions that have prevailed in EM since the mismanagement of the Cold War period. Yet, we think many investors have not yet fully recognised the significance of the growing diversification within the external debt asset class.
Global financial markets have engaged in a giant portfolio shift on the back of QE policies since around 2010. Investors jumped onto the QE markets to ride the momentum created by central bank sponsorship, financing their purchases in these markets by reducing exposure to non-QE markets, including EM. One can think of this as a momentum trade, meaning that the direction of asset prices mattered far more than fundamentals. However, momentum trades always end. Firstly, investors get too long. Returns begin to wane. Secondly, value opportunities elsewhere begin to appear. Value investments differ from momentum trades in that fundamental are also given consideration. This is healthy and bodes well for EM. After all, EM economies have maintained solid fundamentals despite severe shocks in recent years, while valuations have been pushed to extremely attractive levels. By contrast, developed markets look overbought. It is time to rotate those QE trades into the non-QE investment universe, including EM.