Q&A: Emerging markets returning to favour

An inflexion point will come in the second half when sentiment improves and the Fed continues raising rates, says PineBridge Investments.
Arthur Lau
Arthur Lau

To raise or not to raise? That's the question on everyone's lips as the financial markets look to the Federal Reserve's next federal open market committee meeting on March 15 to 16 for guidance whether it will continue raising rates, or return to an easing bias in the face of volatility and subdued global growth. 

Over the past month, FinanceAsia has been running a series of Q&As with some of Asia's leading fixed income investors ascertaining their views.

Arthur Lau is the Hong Kong-based co-head of emerging markets fixed income and head of Asia ex-Japan fixed income at PineBridge Investment.

At the end of 2015, the group had $84.5 billion under management globally, of which $49.4 billion was fixed income. Assets under management in Asia amount to $46.2b billion. 

Here Lau explains why he remains an optimist about growth, the Fed's interest rate policy and investment funds returning to the emerging markets. 

Emerging markets have not been flavour of the month for some time. Will this continue to be the case throughout 2016?

Arthur Lau: True, the asset class has not been in favour for about three years.  But everything has a cycle.

Many companies have gone through the pain now and I think we’ll reach an inflexion point during the second half when sentiment will improve. I also think the commodities cycle will bottom out later in the year as well.

As you can probably tell, we’re definitely not in the bearish camp.

Asia also outperformed other emerging markets last year. Russia had sanctions to contend with, while falling oil prices hurt Middle Eastern countries. Asia had lower volatility and higher overall returns.

If you’re less bearish does this mean you think the Fed will continue raising rates this year?

We think the Fed will normalise policy over this year and next. We’re expecting two or three rounds of hikes.

The market became very bearish at the beginning of the year, but a lot of it was pure sentiment. If you look at the fundamentals, they’re nowhere near as bad as market technicals are implying. The market has traded at an extreme dislocation to fundamentals.

But if the Fed starts raising rates won’t that be bad for emerging markets, as capital will flow back to the US again?

Actually I don’t agree. There’s a lot of tightness in the global system. The velocity of money in the system is very low, which means people are hoarding cash not spending it.

So how have you positioned your portfolio?

We’ve moved from an underweight to a neutral position in general in most of the dollar-denominated portfolios.

Indonesia is a good example of where we’ve reduced the underweight but also reduced the portfolio’s beta by taking profits in some sectors such as the downstream oil and gas sectors. In the commodities sector, we’re reducing our overweight on downstream and becoming more neutral on upstream. Here we were previously underweight.

We’ve also taken some profit in the Indonesia property sector but increased our overweight in quasi-sovereign. So net net, we’ve added positions in Indonesia, which reduces our overall underweight. So, you can think of it as rebalancing from corporate to the quasi-sovereign sector.

Where the banking sector is concerned, we think the non-performing loan cycle in Indonesia hasn’t turned yet. In India it’s only just starting to manifest itself. In China we think the NPL cycle still has longer to run, but some names are starting to present good investment opportunities.

In some local currency portfolios, such as Korean and Taiwan, we have a longer duration bias.  We’ve taken some profits in Indonesia though.

The rupiah has recently rallied a lot. Some local currency markets like Indonesia have had very high carry. There’s a potential capital gain now that central banks are become more accommodating in their easing policies.

As a pan-emerging markets specialist, what differences do you see between Asia and the rest of EM?

The Asian bond market has become a lot more regionalised over the past five years and this has helped credit spreads. It’s really become quite noticeable how big a discrepancy there is between Asia’s view of China and the level of understanding there is in Europe and the US, particularly the US.

I don’t think the Western media does a very good job reporting what happens in China; it’s too resolutely negative all the time.

The emerging markets all tend to get tarnished with the same brush – i.e. corporate governance is bad. But while it’s certainly true their legal systems may not be as robust as Europe and the US, it’s not fair to completely write them all off.

There have been plenty of accounting irregularities in the US over the past decade. It’s just that the frequency tends to be higher in the emerging markets.

EM has gone through many ups and downs, but Asia has survived them all and will continue to do so. When you think about it, the investable universe here is enormous – 13 countries that span the whole credit rating spectrum from Singapore’s triple-A rating to Pakistan’s lowest singe-B rating.

There’s a wide range of sovereigns here, all at different stages of development.

What’s key to understanding emerging market debt then?

It’s all about the politics. That’s really the key even for corporates. You have to understand what each government wants to achieve, what their economic goals are.

Take a look at India and Indonesia. A few years ago it was all about Indonesia, which was riding the commodities boom. But today investors prefer India because they think [Prime Minister Narendra] Modi is doing a good job communicating his intentions and delivering on them. A lot of expectations have been placed on Jokowi’s [President Joko Widodo's] shoulders, but he has to deliver.

China is another good example. It seems clear to me that President Xi Jinping is taking a medium-term approach. He knows the current economic model can’t be sustained so he’ s moving on a number of fronts by cracking down on corruption, reforming state-owned enterprises, improving the environment and investing more in education.

Most importantly of all, he doesn’t want to repeat the mistakes of 2008 when the Chinese government turned the credit spigot on.

How is the asset management industry itself changing?

There’s a structural change going on. Historically, fund managers banks, sovereign wealth funds and insurers have dominated the Asian fixed income market. There’s been very little retail involvement, but that has started to grow over the past two to three years.

The other big change is the advent of Chinese investors.

Does their lack of sophistication make the market more difficult for you to navigate?

They will undoubtedly make mistakes, as some of them don’t know how to price risk properly yet. But the phenomenon will be quite manageable since they only invest in Chinese names at the moment.

You just need to understand their psyche. When they decided to buy a BBB-rated bond offshore, they might treat it like a AA- rated bond if that’s where the company is rated in the domestic market. 

Experienced fund managers should be able to benefit from that because our understanding of credit risk will bring us to a different conclusion.

Can you give an example?

Well there are some Chinese companies with very weak stand-alone fundamentals, but very strong support from their provincial governments. The rating agencies may give them a two-to-three-notch uplift from non-investment grade to investment grade because of this.

But that means there’s a gap between where these companies should price on a pure fundamentals basis and on a rating basis. Pricing normally falls somewhere between the two.

A fundamentals-based investment might think final pricing is too expensive because they believe it should have been fixed at sub investment grade levels. But a Chinese investor might think the pricing is cheap because they consider the credit support of a Shanghai Sasac or a Tianjian Sasac to be rock-solid.

You have to look on it on a case-by-case base. Having said all that it’s generally those deals without much international support, which trade down in the secondary market, so you have to strike a balance. Chinese investors on their own can’t completely support deals yet.

What’s your view of Chinese bank capital paper?

Everything has a relative value. On the surface Chinese banks AT1 (Additional Tier 1) paper doesn’t look cheap compared to similarly rated banks in Europe, which are probably trading about 150bp wider. However, the 5% yield on this paper is very attractive to Chinese retail investors.

They could get the same dividend yield buying the equity of onshore listed banks, but they can’t get the leverage they can through the debt markets.

A lot of international banks don’t hold this view?

And a lot of international banks have been wrong from day one. They initially said AT1 paper was too tight; then it performed very well.

They’re revisiting the idea now European bank capital spreads have widened as investors worry about deflation and global growth.

But I think it’s worth remembering there’s very little subordinated debt in China right now. Basel II and Basel III are relatively new concepts for the Chinese banks. They’ve relied on core Tier 1 capital for a very long time. The next stage will be to raise more Tier 2 debt.

The Chinese banks will have to raise a lot of capital over the coming years and the government needs these market to stay open to support it. Default risk for AT1 paper is very low for now.

What’s your view of Chinese property sector bonds?

I think we’ll start to see more companies come offshore again. The onshore market has been very good to property companies recently. There’s been ample liquidity and they’ve been able to tap the market at tight levels.

However, onshore credit limits are getting used up and it may actually not be that much more expensive to issue offshore even on an after-swap basis.

Why’s that? I thought they were all issuing at tight levels.

Some of the higher yielding Chinese property companies are now finding it much harder to issue because of concerns about a credit bubble. They’re not able to issue at 4% to 5%.

Some of them can’t even get 6% and that’s on shorter tenors than what’s available offshore.

However, this dynamic is counterbalanced by the overall leverage these property companies have. Last month, Moody’s spelt out its rating methodology and made it very clear some of these companies are getting close to breaching the agencies limit on combined onshore and offshore debt.

How would you sum up the market so far this year?

It’s been risk averse. Investment grade has been more favoured than high yield, but investors are just very selective at the moment. We think there’ll be a fair amount of issuance from China and India this year, but the market is definitely looking for a liquidity premium when it comes to pricing. 

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