EMFI Monthly Outlook June 2012Risk-off Intensifying?
Last month we touched on three themes affecting markets: weaker data, the Eurozone, and China. With apologies to readers experiencing a sense of déjà-vu, these three themes have continued to be the drivers of emerging market fixed income performance over May. We’ve just seen the US Payrolls report which was weaker even that the “whisper number”, and last month’s release was also revised down showing that it was not just a statistical artefact coming from the warm US winter. Manufacturing series have also been weaker, but this has been particularly clear in Europe where the PMIs have been dreadful everywhere except Germany, but even there the IFO survey of business climate significantly undershot the forecast. The Eurozone remains the largest single source of uncertainty in markets, with the Greek elections to come mid-month and the chance of a new government rejectingausterity completely, while Spain is moving closer to joining that country, Portugal, and Ireland in a program. Lastly, while the central forecast remains that China will experience a “soft landing” – meaning GDP growth in excess of around 7.5% – indicators ranging from the two PMI series to steel prices are shaking conviction.
These matter, of course, because they are the drivers of the “risk on / risk off” (RORO) environment of highly correlated moves across series of superficially unrelated asset classes. As we have moved well into “risk off” territory, emerging markets have suffered on an absolute basis. But he relationship is not merely one of correlation; the US, Europe, and China remain the engines of global demand, and slowing here would be expected to manifest itself in lower commodity prices for primary producers, and consequently deteriorating fundamentals.
Weakness in emerging fixed income markets has manifested itself across the globe, but most clearly in Latin America in general, and Argentina and Venezuela in particular. The Argentina 33’s have crashed through a series of supports, including that of the last sustained risk-off trade in the autumn of 2011 when they reached 65.00. They have traded through the lows of 2010 and now with a price at time of writing of 58.50, we are looking to 2009 levels. Venezuela has not performed as poorly, but the reference CDS is trading at around +950. Here the issue is less the absolute level – which was similar as recently as January – but the rapidity of the sell-off, from a low of +680 at the beginning of the month. Venezuela is very specific situation, with good liquidity meaning it is an easy risk proxy, but with a highly volatile political dynamic and a exposure to oil, itself perhaps the purest way of expressing the RORO trade, which readers will know has also dropped like a stone to a little over $83/bbl currently. Argentina is facing a number of problems, not the least of which is sharply slowing growth. Yet we are seeing pricing similar to that of the aftermath of Lehman. An unstructured Greek exit could be worse, but it has not actually happened, and it is few investors’ central scenario: the market may be running ahead of itself.
That leaves our preference to be very close to home in fixed income in duration and country exposures. “Risk off” widens bidoffer spreads and makes trading costs high, and we express caution – but it seems premature to be pricing the end of the world. Our cautious stance has been reflected in a basket of currency underweights, which have performed well.
ALPHA STRATEGIES
Emerging markets external debt suffered over the month, with an estimated underperformance of 60 basis points, and the index itself down 2.32%. Duration allocations have been broadly neutral over the month, but with continuing bias in favour of Latin America against Central and Eastern Europe in particular. We began the month overweight Venezuela but trimmed this as oil sold off, and as it became clearer that President Hugo Chavez was continuing to maintain he would run again. His health means that either succession planning is very important, but he has refused to be drawn on the issue. These forces, combined with the risk off environment, put pressure on the market and we moved to buy protection on the CDS.
Emerging markets corporate debt underperformed over the month. We estimate that the strategy underperformed by around 68 basis points, with the benchmark return being -0.92%. High-grade continued to outperform versus high yield, which is not surprising in the environment, and in most sectors portfolio performance closely matched that of the benchmark. There were two main exceptions to this trend, being Brazilian and Kazakh corporates. What these had in common was the names we own are concentrated in the oil exploration sector, and while these are cashflow positive, sentiment suffered with the $20/bbl drop in oil over the month.
Emerging market local currency debt performed strongly in May on a relative basis, with estimated outperformance of 105 basis points, but in the context of poor performance from the asset class overall in the risk-off environment: the benchmark dropped by -7.08%. Performance was driven mostly by FX positioning, with underweights in the BRL, COP, PEN, HUF, ZAR and PLN significantly adding to returns, with the longs in TRY and MXN modestly detracting. The Real in particular has seen strong moves, as the Central Bank has cut rates, and intervened in markets only to slow the depreciation policymakers have made clear they are happy seeing. As we expected, the relief rally in HUF was brief, and while our conviction in the ZAR and PLN positions is quite low they are efficient proxies for the global risk trade.
Alex Johnson – Co-Head of Global Fixed Income, FFTW
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