Fed Waiting Game: An EM Debt Perspective

The VanEck Emerging Markets Bond Fund was down 1.5%, compared to down 2.1% for its benchmark, the 50% J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified and 50% J.P. Morgan Emerging Markets Bond Index (EMBI) in April. Developed market (DM) government bonds (JP Morgan’s GBI Global) were down 2.7%, totally consistent with our view that emerging market (EM) bonds should outperform DM bonds. During April, the Fund initiated or increased exposure to several big local currency markets, which had all sold off during the month including Mexico, Brazil, South Africa, and Turkey. We also added to Nigeria and China corporates in US dollar denominated debt. We continue to think EM local currency and low duration are good answers for the current environment. We end April with carry of 7.3%, yield to worst of 9.4%, duration of 5.0, and 46.3% of the fund in local currency. Our biggest exposures are Mexico (local and hard), Brazil (local and hard), Indonesia (local and hard), Chile (local), and South Africa (local and hard).

^* Returns less than one year are not annualized.

Expenses: Class A: Gross 2.55%, Net 1.22%; Class I: Gross 2.51%, Net 0.87%; Class Y: Gross 2.91%, Net 0.97%. Expenses are capped contractually until 05/01/24 at 1.25% for Class A, 0.95% for Class I, 1.00% for Class Y. Caps excluding acquired fund fees and expenses, interest, trading, dividends, and interest payments of securities sold short, taxes, and extraordinary expenses.

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Are we there yet? More specifically, now that everyone is bearish on Treasuries (and the Fed), is it time to be bullish?

Since everyone is bearish now, let’s start with the bullish side. On the bullish side for rates is the simple fact that four 25 bp rate cuts were priced out of 2024 during the quarter, and recession risks are arguably rising! If this is a pendulum (which it could be), it can swing back. Moreover, there are signs of internal economic weakness in the US, though those redound to forecasting (data such as car loan delinquencies, home affordability, etc.), rather than ex-post evidence. Our EM eyes would also tell us that pronounced political uncertainty always hurts growth, why would the US be any different? To strengthen the argument beyond rising recession risk, which is the main implication of the previous sentence, the Fed’s reaction function doesn’t present any obvious obstacles to allowing rate cut expectations to resume. Higher oil prices are a tax on the consumer to Fed thinking (and whether that is wrong or right, Fed policy is not viewed as being able to manage oil prices, other than in extremely destabilizing ways), so arguably pushes the Fed toward easing. The Fed has been claiming that even though its Financial Conditions Index (FCI) shows easing conditions, the Fed’s messaging has emphasized the simple real rate (which is a dovish framing). Similarly, when I speak with my rates colleagues in the market, I almost get laughed at when I wonder “why wouldn’t a strong disinflationary stance help the political-economic dynamic?” We ask the question because in most EM countries, harnessing a central bank to achieve economic outcomes beyond inflation is a non-starter for voters on the left (and on the right, obviously). Inflation kills the poor and can kill governments, so we would argue that this is a simple observation of global economic history. Anyway, we agree it’s ludicrous to imagine a Fed hiking with open political support, but not ludicrous to say they should (which is what Larry Summers is saying, without our flourishes). And if they should but don’t, well, here we are. There is not much more to say on this potential climax as our conclusion has always been the same – caution on duration. The fund is still strongly biased to be capped at neutral duration at most (though there are always some long-duration assets worth having at moments, which sometimes boils down to a diversification strategy – we can’t be too certain of our view on limited duration, too).

The verdict at IMF meetings, again - EM the winner, DM the problem, all due to “fiscal dominance”.

We clearly won’t let this topic go, and why should we? We discuss it in great detail in our white paper, and recently our teammates Dave Austerweil and Natalia Gurushina’s wrote about it in a full piece on the IMF meetings. The IMF doubled down on the theme at recent meetings. At the annual meeting in October 2023, the IMF made it the focus of the meetings, and that continued at the April meeting! We are not alone; this is a major sleeper issue that too many just ignore. More specifically, there were a couple of interesting framings that emanated around recent IMF meetings. Exhibit 1 shows that the US primary fiscal deficit is extremely sensitive to inflation surprises, whereas EMs primary balances are insensitive to inflation surprises. This is obviously due to high US debt compared to low EM debt, so it epitomizes the fiscal or debt constraint. In other words, if you think US fiscal issues will get solved, you better also expect high inflation.

Exhibit 2 below shows that US inflation is among the countries with higher inflation globally, but it’s recent rise is stark. This is completely consistent with R-star data we used in our “fiscal dominance” white paper, showing EMs’ R-star is declining, and DM’s R-star is arguably rising. If so, that’s deep, though slow. Only a crisis will change this, in our opinion. A final note:  all this analysis essentially lays out tracks and barriers for the fund, we are not thinking about fiscal dominance every day and trading EM based on that view. We are using our EM-focused investment process to do its job, while making sure that the portfolio doesn’t bump into any of the implications of these seemingly nebulous facts. Low duration, high spread, idiosyncrasy, benefiting from higher commodity prices, etc. It just happens that EMs have many winners and DMs have many losers, so we’re in an attractive alpha territory in EM bonds.

Exhibit 1 – US Primary Deficit Depends on Inflation, EM Primary Deficit Does Not

Source: International Monetary Fund, Data as of April 2024.

Exhibit 2 – Inflation Is High and Moving Higher in the US, Not EM

Source: Deutsche Bank, Refinitiv, Haver Analytics.

Is China a good story?

It sure looks like a name with extreme bearish positioning combined with good fundamental news, and we all know what Paul Tudor Jones said when the technical and the fundamental line up. Policy is firming, with the government signaling that it will support project completions on swaths of ongoing building. And there’s the Purchasing Managers Index (PMI) showing expansion. US officials essentially confirmed all of this by expressing concern of “overcapacity”, which to other eyes is simple productivity and competitive advantage. In fact, that’s a teachable moment, as since at least 2008 the US and DM abandoned many orthodox playbooks because, well, it would be painful. Fair, but not an attractive investment context for the DM, as investors must pay for this political risk. Ultimately, China looks set to face higher US and European tariffs, and sanctions from the US are basically on long-term autopilot to “more”, so we remain nimble and cautious. But, for us in China, that continues to mean small, diversified exposures to beaten-up names. China has been a “little engine that could”, with small exposure doing a lot of work. But we can’t marry the trade.

Exposure Types and Significant Changes

The changes to our top positions are summarized below. Our largest positions in April were Mexico, Brazil, Indonesia, Chile, and South Africa:

• We increased our local currency exposure in Mexico, South Africa, Turkey, and Brazil. Mexico’s central bank sounds very cautious on the pace of policy easing while domestic activity is firming. South Africa’s growth gauges also look more encouraging, and the economy can further benefit from China’s recovery. A lot of political risks are already priced in, and the latest polls point to a more manageable and less radical governing coalition. Brazil’s valuations look attractive, and the currency was lagging the peers, affected in part by concerns about Petrobras dividends, which had subsequently been resolved. Finally, Turkey’s policy U-turn is firmly in place after the local elections, the central bank remains hawkish and vigilant, and there are now good prospects for capital inflows and fewer reasons for capital flight.
• We also increased our hard currency corporate exposure in China, Singapore, and Argentina, as well as hard currency sovereign exposure in Argentina. We are seeing more signs of economic adjustment in Argentina, including fiscal performance, the current account balance improvement, and higher international reserves. There are further attempts to keep the policy U-turn going, and the key reform bill is now in the parliament. China’s economy continues to recover, and authorities signal more policy support with an emphasis on real estate, which can be a much-needed catalyst both for the sector and domestic consumption. Singapore’s bond was a new and attractively priced issue. 
• Finally, we increased our hard currency sovereign exposure in Nigeria, El Salvador, Bolivia, and Bahamas. In Nigeria, we are seeing more positive signals on the policy front, especially the exchange rate unification and tight monetary stance. El Salvador issued a new bond which eased their payment schedule. The Bahamas government is deleveraging aggressively, and the IMF meetings suggest that there can be less deviation from the 2024 fiscal target. In Bolivia, the senate authorized USD325 million in external financing and a major sugar mill announced a sizable investment project to boost its ethanol capacity.
• We reduced our local currency exposure in Poland, Colombia, and Malaysia. Poland’s central bank and the government might be too busy playing political games, while inflation might accelerate a lot if price caps are removed. The country’s valuations also do not look attractive. Colombia’s fiscal concerns refuse to die down, and the Minister of Finance just added more fuel to the fire by saying that he wants to make the already stretched fiscal rule more “flexible”. A major disadvantage in Malaysia is that its low-carry currency is highly correlated with the Chinese renminbi.
• We also reduced our hard currency sovereign exposure in Saudi Arabia, United Arab Emirates, and Qatar. Saudi Arabia might be moving from twin surpluses to twin deficits, and this is not reflected in valuations. A lack of a clear medium-term fiscal strategy also generates confusion against the backdrop of seemingly “never-ending” issuance as new debt is more expensive and the maturity profile gets heavier. Duration concerns were a major consideration in Qatar, especially if the U.S. Federal Reserve has less room to cut. The United Arab Emirates’ status as a proxy for global duration was the reason we decided to use the position as a funder for more interesting opportunities.
• Finally, we reduced our hard currency sovereign exposure in Romania. Romania’s pre-election fiscal spending and political noise create a worrisome backdrop, with additional concerns coming from a citizenship bill which might potentially require military intervention in neighboring Moldova if the Russia-Ukraine conflict escalates and spreads further.