Credit risk in today’s fixed income environment
January 9, 2019
American Funds video transcript: “Emerging markets debt likely to hold ground, despite volatility”
Apu Sikri: Let’s go to emerging markets, Rob. We've seen a selloff in many emerging markets. How high is the risk of it becoming systemic and more widespread?
Rob Neithart: I judge the risk to be rather low, at this point, of a systemic, kind of touches-all-countries, significant movement wider in emerging markets risk premiums. But there's a key reason. I don't feel that the global economy is really at risk of another recession, or even a recession scare. If you just go back as recently as late 2015, at that time there was significant stress in many emerging markets around the world. Interest rate spreads had widened significantly, currencies depreciated dramatically and corporate risk premiums were widening.
That was a period where the world was fearful that recession was looming. China was significantly depressed. Many forecasters were calling for a recession in the United States. And it was not unreasonable. I mean, virtually every indicator of activity was pointing south. They were all deteriorating rapidly.
And in the end, we didn't have a recession, because China stimulated and other central banks increased their easing and support of the market. But I think also people mistook a normal kind of cyclical adjustment in the industrial sector for something that was going to spin out of control. Once the industrial sector cleared out the inventories, everything picked right up again. And we had a strong phase, for both markets and the global economy.
Today, I don't see evidence that the cycle is at risk. The Chinese have taken steps to significantly ease. We have a lot of stimulus coming through the United States on the fiscal side. The Japanese and the Europeans are in no hurry to tighten, because I don't think that they want to be facing the risk of a downturn. Nor do they have any reason to, because inflation remains very low.
That's the kind of environment that would, I think, push risk premiums in emerging markets significantly wider, because it is a cyclically sensitive, growth-dependent asset class. What we've seen, though, are a number of situations that are simultaneous — coincidental with each other — of individual country stress. We did have a period of worries about China — we still do, it's not over — but those concerns have become a little more relaxed. Anxiety about the Fed maybe tightening aggressively. And then you had problem countries for their own domestic reasons — the likes of Turkey and Argentina — really developing difficulties.
Those situations have started to fix themselves normally, meaning the market pressures have caused an adjustment to take place. It’s textbook adjustment. I mean, Turkey's economy has moved into recession. Their current account and external balances have swung dramatically back into surplus. The supply and demand in the system for Turkish lira has stabilized. And they've raised interest rates. Argentina is following the same path. And I think they're likely to continue on that path.
Apu Sikri: It's interesting. The emerging markets adjust quicker through market mechanisms, you would argue, than even ... We just talked about Europe, so —
Rob Neithart: Yeah, they have fewer resources to draw from, and they have fewer degrees of freedom. So, the ECB can do a lot more than the Bank of Turkey or Argentina's central bank. They're more exposed and, therefore, when the pressure is on, they have to accommodate.
So, the major concerns are mostly geopolitical. Is leadership in Turkey going to stick to the program or are they going to just say, “Forget it. We're just not going to pay our debts” and stiff all the creditors. Same thing in Argentina. Are they going to stick with the program? They have support from external lenders. The IMF is in there.
Apu Sikri: When you look at the local markets, where are you seeing opportunity and where do you see further downside risk?
Rob Neithart: So, I find value in places today like Mexico, believe it or not Turkey, as well as Argentina. They need to stay on the path that they're on, but the risk premiums are high enough to get me interested. In addition, I think there are some markets in Asia. Yields are lower, but I do find attractive opportunities in local currency Indian bonds, local currency bonds in Thailand, for example. Russia is a completely different situation. If I could take the risk of sanctions away — which you can't do it but if you could — Russian domestic debt instruments are phenomenally attractive. Russia is almost entirely self-sufficient on financing. It actually doesn't even need to go to the market to finance itself. So, I need to judge the risk that there are sanctions and how long or severe those sanctions might be.
But that's a basic reality of emerging markets investing — volatile economies, geopolitical risks, unpredictable politics — but very high risk premiums that can produce excellent returns over long periods of time.
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