For Investment Professionals2017 Market Insights

Simon Quijano-Evansis an emerging marketsstrategist at LGIM, focusedon allocation and macrostrategies for the EM fixedincome funds

EM Outlook 2018What challenges do emerging market bonds face after two strong years?

With the European Central Bank and US Federal Reserve

set to be in tightening mode throughout 2018, emerging

market (EM) assets have a tough act to beat. 2017 will go

down positively in history as the ‘big surprise’ for most

emerging markets pundits, with flows into the asset

class well above expectations after an already strong

2016. And, all this happened in spite of clear challenges

from an imminent shift in US domestic and foreign

policies (Figure 1).

Looking into 2018, US policies will remain one of the

biggest focal points for EM assets, even if it has felt

like ‘waiting for Godot’. EM local currency assets will

closely watch the effects of US tax cuts, given possible

US-dollar strengthening pressure from a more ‘introvert’

US economic policy. EM hard currency assets, on the

other hand, will be focused on a more ‘extrovert’ US

foreign policy, as partly reflected in the ‘political spread’

(or ‘p-spread’) that separates countries like Mexico,

South Korea and the GCC (Gulf Cooperation Council)

from their EM peers (Figure 2 overleaf).

40%

35%

30%

25%

20%

15%

10%

5%

0%

-5%

2017 YTD 2016

EM

EQ

Eu

rozo

ne

EQ

SP

X

US

HY

EM

LC

Bo

nd

s

EGB

US

T

EM

BIG

D

EM

Co

rp

Figure 1. Strong returns for emerging markets in 2016 and 2017

Source: Bloomberg

Total returns in US$

18 Dec 2017

An update from the Fixed Income team

2

2017 Market Insights 5Y

CD

S S

pre

ad in

bp

s

Avg ratings of S&P + Moody’s

250

200

150

100

50

0AAA AA+ A+ A- BBB+ BBB BBB- BB+ BB BB-AAA AA-

“P-Spread”

18 Dec 2017EM = Blue and greyNet energy exp. = Blue

AUSAT BEL

BRA

CL CN

CO CRO

CZ

FRGER

HUID

IRE

ITA

JP

LAT

MAL

MX

NL

PE

PHPL

PTRO

RU

SK

SOAF

KO SPA

TH

TR

UK

MO

BG

SRB

AD

S.ARQA

KAZ

ISRPAN

UR

KW

0%

1%

2%

3%

4%

5%

6%

7%

Ind

ia

Ch

ina

Ph

ilip

pin

es

Ivo

ry C

oas

t

Ind

on

esia

Ser

bia

Ro

man

ia

Mal

aysi

a

Gh

ana

Mo

rocc

o

Po

lan

d

Hu

ng

ary

Tu

rkey

Uru

gu

ay

Cro

atia

Per

u

Co

lum

bia

Kaz

akh

stan

Ru

ssia

Ch

ile

Mex

ico

Bra

zil

So

uth

Afr

ica

Figure 2. The ‘P-Spread’ or political spread that differentiates the EM bond space

Figure 3. Domestic politics have been a drag on growth in Brazil and South Africa

INCREASINGLY IDIOSYNCRATIC EM RISKS

One can’t obviously ‘blame’ everything on developed

market (DM) challenges, but EM-specific risks have

become more idiosyncratic and less systemic over the

past few years as the EM world gradually ‘matures’,

supported by G3-driven central bank liquidity. Prime

examples are Brazil and South Africa, whose domestic

politics have pulled down their respective countries’

economies, at a time when the rest of the world is in

recovery mode (Figure 3).

Fortunately though, central banks in most of the EM

world have played a much-needed stabilisation role, as

seen in the outperformance of both the South African

rand and the Brazilian real versus the Turkish lira,

which continues to struggle with its own politically

challenged central bank (Figure 4). Indeed, the move

to a more flexible exchange rate policy in much of EM,

coupled with the increase in central bank credibility, has

been a confidence booster for EM assets over the past

few years.

Source: Bloomberg

Source: IMF WEO

Avg. annual Real GDP minus Pop.

growth 2017-22F (IMF forecasts)

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Market Insights 2017

70

80

90

100

110

120

130

140

Jan

-16

Feb

-16

Mar

-16

Ap

r-16

May

-16

Jun

-16

Jul-

16

Au

g-1

6

Sep

-16

Oct

-16

No

v-16

Dec

-16

Jan

-17

Feb

-17

Mar

-17

Ap

r-17

May

-17

Jun

-17

Jul-

17

Au

g-1

7

Sep

-17

Oct

-17

No

v-17

Dec

-17

TRY BRL ZAR RUB IDR

7 1,000

900

800

700

600

500

400

300

200

100

0

6

5

4

3

2

1

0

-1

Fed Rate (LHS in %)

Jan01

Jan00

Jan03

Jan02

Jan05

Jan04

Jan07

Jan06

Jan09

Jan08

Jan11

Jan10

Jan13

Jan12

Jan15

Jan14

Jan16

Jan18

Jan17

UST10Y-UST2Y yield (LHS in %) JPM EMBIGD Spread in bp (RHS)

Figure 4. TRY sticks out by far

Figure 5. EM spreads like the US curve flattening

Source: Bloomberg

Source: Bloomberg

OIL PRICES CHALLENGE 2018 INFLATION

This brings us to the question of inflation. While the US

Federal Reserve continues to deal with its Taylor rule

conundrum and the issue of why low inflation could be

with us for longer, the market is pricing in around 50

basis points of US rate hikes in 2018. EM spreads have

been happy with the ensuing US treasury yield curve

flattening, in a similar way to 2007 when spreads reached

their all-time lows (Figure 5). And, while curve flattening

may raise some concerns about where we stand in the

global economic cycle, global pension funds seem likely

to continue their quest for higher returns further down

the individual yield curves. In the last 12 months, that

has passed through into an unprecedented amount of

30-year bond issuance out of single-B rated sovereigns

in emerging markets, such as Nigeria and Argentina,

with the latter even managing to issue a 100-year US

dollar bond.

FX vs 50/50 USD/EUR basket

Jan-16=100 (Higher = weaker EM FX)

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2017 Market Insights

-60%

-40%

-20%

0%

20%

40%

60%

80%

Jan-

14

Mar

-14

May

-14

Jul-1

4

Sep

-14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-1

5

Sep

-15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-1

6

Sep

-16

Nov

-16

Jan-

17

Mar

-17

May

-17

Jul-1

7

Sep

-17

Nov

-17

Jan-

18

Mar

-18

May

-18

Jul-1

8

Sep

-18

Nov

-18

Brent at $75pb until end -18 Brent at $70pb until end -18 Brent at $65pb until end -18

Latam (CO, CL, MX) EM Asia (IN, ID, ML, PH) BZ TR CEE (CZ, HU, PL, RO)

- 2

0

2

4

6

8

10

12

14

Jan

-09

Ju

n-0

9

No

v-0

9

Ap

r-10

S

ep-1

0

Feb

-11

Ju

l-11

D

ec-1

1

May

-12

O

ct-1

2

Mar

-13

A

ug

-13

Ja

n-1

4

Jun

-14

N

ov

-14

A

pr-

15

Sep

-15

Fe

b-1

6

Jul-

16

Dec

-16

M

ay-1

7

Oct

-17

Figure 6. Various oil price scenarios and the YoY effect

Figure 7. Regional emerging market inflation patterns

Data source: Bloomberg

Source: Bloomberg

That is not to say that the inflation ride is going to be an easy

one for EM central banks in 2018. Indeed, they are likely to

be faced with an increase in oil prices versus 2017, coupled

with a corresponding rise in inflation expectations. Brent

Given that few expect this to be a multi-year trend of

higher oil prices, EM central banks could be faced with a

conundrum of their own, probably turning into a stop to

rate cuts in 2018 rather than a big hiking spree (especially

as regional inflation patterns still look benign – Figure 7).

oil prices for example at USD65 a barrel until the end of

2018 would mean year-on-year (YoY) oil prices remaining

at around 20% until Q3 and spiking at 35% in June

(Figure 6 plots various oil price scenarios).

However, oil price dynamics do stand as an increasing

interest rate risk if accompanied by a stronger US dollar

and/or higher US treasury yields, bringing us back to the

US policy challenges for EM.

%YoY Brent price under

different scenarios

CPI in %YoY

(Avg of countries in each region)

5

Market Insights 2017

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

Ru

ssia

Po

lan

d

Tu

rkey

Ven

ezu

ela

Arg

enti

na

Ind

on

esia

Leb

ano

n

Hu

ng

ary

Mex

ico

Ro

man

ia

Lith

uan

ia

Eg

ypt

Bra

zil

Ph

ilip

pin

es

Co

lom

bia

Cro

atia

Ser

bia

Uru

gu

ay

Ecu

ado

r

Ukr

ain

e

Sau

di

Ar.

Bel

aru

s

S.

Afr

ica

Do

mR

ep

Per

u

Ko

rea

Bah

rain

Nig

eria

Pan

ama

Latv

ia

Interest Principal

Interest Principal

Figure 8. 2018 elections for two-thirds of the Latin American population

Figure 9. The main 2018 sovereign repayments in emerging markets

Source: IMF WEO, parliaments, IFES, Reuters

Source: Bloomberg

ELECTIONS VERSUS BOND SUPPLY

With multi-country elections in 2018, politics will remain an

idiosyncratic risk for a number of EM countries, foremost

driven by the presidential/parliamentary elections in Latin

America (Figure 8 highlights the upcoming elections that

involve around two-thirds of the continent’s population).

Brazil, Mexico and Colombia (which make up around

12% of the EMBIGD Index) clearly stand out as the three

elections that could surprise in any direction, although

opinion polls in Mexico already seem to point to a win by

left-of-centre candidate Lopez Obrador. Significant 2018

elections elsewhere in EM include Russia (18 Mar), Egypt

(before May), Iraq (12 May), Lebanon (May), Hungary

(Q2) and Pakistan (likely Aug).

And, while politics continue to catch the eye of the

EM investor, supply versus demand dynamics remain

constructive. It is difficult to see 2018 flows into EM bond

funds outdoing the 2017 record year, given a tighter US

monetary policy backdrop with the Fed hiking rates and

working its way through quantitative tightening or ‘QT’.

However, 2018 EM sovereign principal repayments are

around US$4bn lower at US$32bn (Figure 9 shows the

main sovereign repayments), sub-Saharan Africa still

faces small amounts of redemptions, and all the ‘over-

issuance’ in 2016 and 2017 provides EM sovereigns with

an additional buffer. On the foreign exchange reserves

front, though, the likes of the South African rand and the

Turkish lira remain the most vulnerable.

Colombia: 49 (11 March and 27 May)

El Salvador: 6.3 (4 March)

Paraguay: 6.9 (22 April)

Costa Rica: 4.9 (4 February)

Rest of Latin America: 218Mexico: 122 (1 July)

Brazil: 206 (7 October)

Eurobond principal and interest payments

in 2018 in USDmn

Latam: Population in mn

and election date

(Pres/Parl)

6

2017 Market Insights

Important Information

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LGIM is authorised and regulated by the Financial Conduct Authority.

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M1589

Figure 10: The return matrix for various potential scenarios

Source: Bloomberg, JP Morgan

BOTTOM LINE

2018 looks set to be a challenging but also engaging year

for the EM fixed income universe. The risks: tighter G2

monetary policies and a more ‘introvert’ US economic policy,

idiosyncratic EM political noise, a potentially uncertain EM

inflation backdrop and, as always, any disruption to the

Chinese growth story. The supporting factors: any continued

US curve flattening and residual cross-over demand in the

first half of 2018, sustained but visibly lower EM spread/carry

pick-up and a benign EM external debt repayment schedule.

On balance, an environment that appears more conducive

towards hard currency bonds in EM, with the EMBIGD

Index offering a 5% yield buffer against any upside risks in

US treasury yields and EM spreads (Figure 10 highlights

the return matrix for various scenarios), while still allowing

for exposure to individual higher-yielding picks that have

a reform story to sell or are in the process of creating

one. That includes the likes of Argentina, Ukraine, Nigeria

and Angola.

Total returns in EMBIGD based on spread and UST yield changes

US 10yr yield

EMBI GD spread

-75 bp205

-50 bp230

-25 bp255

0280

+25 bp305

+50 bp330

+75 bp355

-75 bp 1.70 15.4 13.7 12.0 10.3 8.6 6.9 5.2

-50 bp 1.95 13.7 12.0 10.3 8.6 6.9 5.2 3.5

-25 bp 2.20 12.0 10.3 8.6 6.9 5.2 3.5 1.8

0 2.45 10.3 8.6 6.9 5.2 3.5 1.8 0.1

+25 bp 2.70 8.6 6.9 5.2 3.5 1.8 0.1 -1.6

+50 bp 2.95 6.9 5.2 3.5 1.8 0.1 -1.6 -3.3

+75 bp 3.20 5.2 3.5 1.8 0.1 -1.6 -3.3 -5.0