Think Tank 2022

Outlook and opportunities in emerging market debt

By Gustavo Medeiros

Gustavo Medeiros, Head of Global Macro Research at Ashmore, shared his global macro-outlook views, as well as potential implications for Emerging Market assets, including China real estate bonds - at the Think Tank investment conference. This was Hosted by Momentum Global Investment Management on 8th September 2022.


Robert White: It gives me great pleasure to welcome our next speaker onto the stage, Gustavo Medeiros. Gustavo is the Head of Research at Ashmore, a global emerging market debt specialist based here in London. Gustavo's got great experience managing both local and hard currency mandates, and he's certainly a passionate communicator on all things macro. If our debates over dinner last night are anything to go by, we're in for a real treat today. Without any further ado, Gustavo, welcome to the stage.

Gustavo Medeiros: May we live in interesting times, right? I think you everyone here has been getting a lot of very interesting presentations from various different managers, but I'd like to start mine with some global macro thoughts, because I think we are at a very, very different moment, and that the portfolios we are building for the next 10 years will probably have to be very different from the way we built portfolios over the last 40 years. There are many, many structural changes in the global macro backdrop that will call for that.

I'd like to start discussing by some of these changes. First, as you can see, I have three topics on the short-term and two topics on the long-term. In the long-term, there are two crucial changes in the global macro environment. First, we have to get ready to invest in times of geopolitical conflict. Obviously, we have a war in Ukraine, a war within Europe, which was unthinkable before.

But over the last five years, the two largest countries in the world, the United States and China, have been engaging in every aspect of conflict – from a technological conflict, to a political conflict, to a trade conflict. They are in a conflict-driven relationship in all aspects except for an actual war. It's a very complicated environment.

It's also interesting because most of us that have been working in finance for the last 20, 30 years, have learned to invest and to think about the macroeconomic backdrop, monetary policy, fiscal policy, political risks, you have to insert the geopolitical risks on part of it.

So, our heroes or those people that inspired us: George Soros, Stan Druckenmiller, Mark Coombs (who I worked for), they were very good at anticipating global macro backdrops based on monetary policy on these events.

Now, I have to read more John Maynard Keynes, what he was writing about how to invest in the Second World War. We have to read more about who made a killing during the Napoleonic Wars when ultimately, Napoleon got defeated. Luckily, in a slightly less daunting picture, there are two rules of thumb that have been working fairly well over time.

The first rule is that you want to invest in countries and companies that are neutral to the conflict. These companies and countries can capture arbitrages on trading across both factions. Think about India, for example, where Apple just announced an investment of a new factory. At the same time, India is buying Russian oil at a 30% discount, effectively looking after its own self-interest.

The second rule is that obviously, you want to buy the winners and sell losers of geopolitical struggles and conflicts. It's very hard to say who will be the winner of the economic disputes between China and the United States today, but if you don't know who is going to be the winner, you should diversify your assets. Don’t put all your eggs in one basket because you don't want to be caught in a position where you have allocated a lot of assets with the loser of a geopolitical conflict.

Onto the second point, as I think you've heard many times here, we're going to get a much different environment in terms of growth, inflationary backdrop. Over the last 40 years, 70% of the time or 70% of the years, developed world economies were in what we called a ‘Goldilocks’ environment, which has been a phenomenal environment for investors of above average and above trend growth, but also below average and below trend inflation – on the slide it's the top left on the quadrant.

However, I think that over the next 10 years, we're going to be alternating much more across the other three quadrants, which is either an economic boom that we've been living since pretty much the fourth quarter of 2020 and policy makers overlooked that, or we're going to be discussing whether we're going to enter into an environment of stagflation, which is looking pretty likely in Europe, or at least we're going to get a recession.

There are five key structural reasons why I think we're going to see a very different environment from Goldilocks, although none of them relate to the war in Ukraine which is in my view just accelerating that trend. The first reason is that we have too much indebtedness in the world, particularly after the fiscal response to COVID. That response will force central banks to keep policy rates at negative levels in real terms. Otherwise, economies are going to suffer significantly. So, I see central banks reacting in a similar fashion to what they were doing in the late '60s, early '70s. They were always going to try to react, and try to fight inflation, but they were never going to do enough to actually kill inflation once and for at all. This is particularly important considering we have two other factors echoing the ‘60s and '70s.

If you remember in the 1960s, one of the most important policies coming from the United States was ‘big society’ by Lyndon Johnson, which was trying to reverse inequality back then. When you reverse inequality, you actually take money away from people that have allocations in financial assets and give it to poor people, which at the end of the day translates into more demand for commodities. That’s exactly what we've been seeing since COVID.

In many respects, COVID was a slap on the face of society, and of politicians, as it showed how inequality has been grotesquely widening over the last 40 years. If you were part of the top 1% of the population, you had a pretty good time during COVID. Yes, it was very stressful, and it was complicated, and while were fearing for our lives and for our loved ones, if you lived in a dwelling in India, that was proper hell. Across the world, governments are trying to put policies in place to reverse inequality. Typically, that leads to a super cycle in commodities. I don't think this time is different.

Together with that, we're talking about energy transition. So far, the finance industry overall adopted a fairly thoughtless approach to energy transition, by trying to kill supply of fossil fuels, which is responsible for 80% of our energy matrix. That is obviously going to create energy shortages, and these were compounded by the Ukraine war. But right now, things are tight in terms of supply of oil, copper, and all industrial metals at a time that the reverse of inequality is going to lead to higher demand.

We are also going to start to see increased regulation in big tech which we haven’t really seen over the last 10-15 years. And as a result of inequality, and then a pushback against this hyper globalisation, we’re going to see a build-up of supply chain redundancies. We cannot have China producing everything that we consume in the world, particularly given the geopolitical backdrop. So, these issues are important to keep in mind in the long-term.

In the short-term, we have seen three key issues play out this year. The first has been China's zero COVID-19 strategy leading to a stronger economic slowdown than anybody expected for the Chinese economy. The second is the pronounced monetary policy tightening by the US Federal Reserve (Fed). In my 22-year career I’ve never seen the Fed make two consecutive 75 basis points cuts. You have to go back to the Volcker era to see such aggressiveness. But after being behind the curve for at least 12 months, the Fed has over-reacted and is now hiking into an economic slowdown caused by the war and supply shortages.

And finally, to the Ukrainian war. I think here, the important thing to understand is the unintended consequences of economic sanctions, which as we've been learning now in Europe have been even more grave than the intended consequences.

This is a map showing which countries voted to suspend Russia on the membership of the Human Rights Council, those that abstained, and those that were against the suspension. 

Overall, the overarching conclusion is that the vast majority of Latin American countries, including Brazil and Mexico, and most African countries and most of central Asia, remained neutral to the Russia/Ukraine conflict and are likely to remain neutral to any geopolitical struggle that comes. It’s a simple economic reality that these countries cannot detach or decouple themselves from either the United States or the Chinese economies.

This chart is very interesting. It is very long-term chart that shows the history of real interest rates over the last 700 years. It is a chart published in a paper by in the Bank of England. What I'm interested in here is the period right after the First and the Second World War, when the global central banks kept monetary policy below inflation for a decade-plus.

 If you look at the fiscal expansion that we had during COVID, this environment is comparable to the First and the Second World War fiscal expansion. I think that's what we're going to require. This chart finishes in 2018, but it you were to update it to more recently, you'd see inflation hit 9% when the Fed funds rate was very close to zero. We're now going slightly back towards the -5% area as the Fed funds rate increases and inflation declines. This is the inequality picture that I mentioned. The top 1% of Americans used to control 10% of aggregate income in the 1980s. Today, they control close to 20%. The bottom 50% used to control 20% of the aggregate income. Today, they have about 13%. That's mega deflationary, because it is taking money away from people that have pent-up demand for food, shelter, cars, all durable and non-durable goods, which translates into demand for the real economy, and giving it instead to the wealthier part of the population.

These people are going to buy S&P500 stocks, emerging market bonds, and financial assets. So, the reverse of inequality obviously has to be inflationary, and that's where we're going.

Just to give you an order of magnitude of the importance of commodities, Citibank estimates that in 2019, the world spent about $6.3 trillion in commodities. Today, we're talking about $12.5 trillion dollars. The share of commodities as a percentage of global GDP has increased from 6% to 13%. Again, the energy transition is part of it. This table of key energy components shows that in 2020, 83% of our energy matrix was dependent on fossil fuels. There is no transition to clean energy that doesn't require fossil fuels in the short-term. Therefore, starving this sector out of capital is complicated.

Thoughts on China

China has been a key deflationary force over the last 40 years, not only because it has a billion people joining the labour force, but also because they've expanded their energy consumption via burning coal. If you're an environmentalist, coal is a terrible source of energy. However, if you're an economist, it's a fantastic source of energy as it’s low in terms of volatility and its price level is lower than most other fossil fuels.

In fact, China burning coal allowed the world to produce more goods much cheaper. But now, China is committed to the energy transition and 90% of the solar panels manufactured today come from China, as do most of the world’s wind turbines. China understands that it is part of its strategic plan to clean up China's air and to clean up the world's air. Today, China and India are committed to cleaner air, and while Europe and the US are also deeply committed, the process of this energy transition remain complicated and open to question.

In the short-term, I'm seeing a lot of deflationary forces in the global economy. So, while I think that over the next decade, we're going to be in a much more inflationary environment, over the next six months, I see a lot more of this inflationary pressure.

So, on the bottom right of the quadrant, you see commodity prices rolled over from their lows. Industrial metals in particular are below where they were one year ago, so declining year-over-year terms. Gasoline prices, a key component which affects all goods and services in our society, have been declining quite significantly since mid-May.

On the bottom left, you see the house affordability in the United States is very similar to the picture in the United Kingdom, and is very soon going to also look very similar in Europe. You can see that the average worker in America used to have to deposit 11 months of their income to buy an average house. Today, they have to deposit about 17-18 months or months. And their mortgage payment will take close to 50% of their income today, which is twice what it was only two years ago. Obviously, that's a consequence of higher house prices and higher interest rates cost.

On the top left, you see that real wages have been running already at negative levels for 12 months. If we start getting unemployment as a result of that, and in the top right, you can see the quit rates have peaked and is a good leading indicator for wages, we think we're going to get a lot of pressure taken off the labour market.

Interestingly, if you look at the leading indicators such as the Purchasing Managers’ Index (PMIs), the developed world economy seems to be slowing down, which is consistent with a recession. The composite PMIs, the combination of the service and manufacturing PMIs, are below 50 levels, and manufacturing PMIs have been decelerating quite quickly, having dropped five points in the developed world to 51.3.

Interestingly, emerging markets are bucking the trend to the extent that PMIs are actually improving there. Manufacturing is picking up in the emerging market (EM) countries. The vast majority of EM countries are getting new orders and output positive growth – PMIs are above 50 and actually improving.

It’s therefore interesting that against this environment of a recessionary backdrop in the developed world, EM is doing much better. Now, EM has been going through a very rough time over the last 18 months. You can see on the left-hand side of this chart, the performance of local bonds overlapped with the Fed fund rates. Typically, local currency bonds actually perform quite well on the Fed hiking cycle. The best time performance horizons for local currency bonds was from 2003 to 2008, and from 2015 to 2019, when the Fed was actually increasing interest rates on a moderate basis, giving plenty of signals to the market in advance.

Today, the problem we have is that the Fed has been extremely aggressive, and we cannot yet figure out what is going to be the terminal rate. So, the fear of the Fed and repricing is still with us. At the same time, because of the disinflationary points that I mentioned, and because we will see this rate hike impacting the labour market quite soon, we're talking about a recession, which is also an environment that is not positive for EM.

But bearing in mind that the total return of local currency bonds have been at close to -20% over the last 12 months, and the big gap between commodity prices and local currency bonds, which typically has a very strong correlation, I think that this is a massive value opportunity which we should be able to harvest quite soon.

One of the reasons why local currency bonds have not performed well is that EM currencies have been underperforming. This chart is a nominal EM currencies chart that shows EM currencies depreciated by basically 50% of their value, from 140 to 70. On the left-hand side, you have currencies in real terms, in real effective exchange rate. You can see that the mirror image of EM depreciation in real terms has been a very strong appreciation of the US dollar. That's exactly the key reason why EM assets have been on the back foot. The dollar plays a huge role into what happens to financial flows around the world, and EM is not exempt from that.

The main reason why the dollar has been on a tear over the last five years is because the US has been running pro-cyclical fiscal and monetary policy. Since Donald Trump was elected, the US has been running massive fiscal expansion. The first thing Trump did when he came to power was to cut taxes for American corporations. If you're a global equity manager, you're looking at the bottom line of American corporations improving as a result of lower taxes – not Mexican companies, Japanese or European companies. So, as a global equity manager you're going to sell your stocks in the rest of the world and buy stocks in the US.

And of course, the first thing Joe Biden did when he came to power was further pro-cyclical fiscal policy in the form of COVID pay checks. In fact, everything that comes out of Joe Biden is pro-cyclical. There is more fiscal spending there. So now, the American economy is extremely imbalanced. If you look at the amount of capital that foreigners have invested in the US, we're talking about basically $2 trillions, whereas Americans have only $34 trillion invested in the rest of the world. That gives the US a net liability of about $17.5 trillion dollars, which is equivalent to 72% of GDP, which increased from $8 trillion before Trump.

In other words, there was $10 trillion of capital going into the United States in excess of capital coming out of the US, which means that most of the assets of the world have been allocated at the margin over the last 10 years into US assets, which are (unsurprisingly) extremely expensive at this time. No EM economy would be ever allowed to run such a massive imbalance – the currency would be already selling off quite significantly in that result.

The last bullet point on the slide shows the breakdown of foreign ownerships on the asset side. So, foreign investors today own $7.5 trillion dollars of US Treasuries and $15 trillion of US stocks. In a proper risk-off environment, where investors decide to get out of stocks, the US should suffer, because typically, the dollar rallies in a risk-off environment because people buy US Treasuries precisely to protect their portfolio in this environment. But it hasn't been really working so far in 2022, because of the Fed’s inflation reaction.

This chart is the most interesting, as it explains why I care a lot about the dollar. This chart shows the ratio of the total returns of the MSCI EM index (without including dividends) to the S&P500. As you can see it follows the dollar pretty closely. From 1995 to 2002, the dollar strengthened by about 35%, and EM stocks massively underperformed the S&P500. From 2002 to 2012, China became the world’s key producer of manufacturing goods, and there was a lot of investment into emerging markets and commodities were doing quite well. The dollar depreciated about 35% and the ratio of MSCI EM to the S&P came from 30 at the bottom to 120 at a peak. In other words, a four times outperformance in emerging market stocks versus the S&P500.

Now, nobody wants to know about EM assets, stocks, or debt, because over the last 10 years, it has been such a tough environment. The dollar has been strengthening, commodity prices have been declining, and the multiples of EM stocks have been derating, whereas US stocks have been rerating, explaining the massive underperformance.

In my view, the next leg of the cycle is going to involve investors getting out of overly-expensive consumer discretionary, tech stocks, and those assets that benefited from the globalised, low inflation, Goldilocks environment over the last 10 years, and looking instead to buy into value, into commodities, into those areas that will be important in a world trying to reverse inequality, and trying to carry out the energy transition. Those are emerging market assets.

Within the debt space, you can see that the sovereign debt part of the asset class is trading at close to 1,000 basis points over US Treasuries, pretty much the same level that we traded at the worst moment of the 2020 COVID crisis and the same level that we traded in 2008-2009.

Obviously, within the sovereign space in EM debt, you have several countries that are going through balance of payment crises. But not the large emerging market countries like China, Mexico, Brazil and Indonesia, those countries are doing just fine. Most of their debt is in local currency, so they don't have a dollar debt problem, and the dollar’s appreciation does  not affect their balance sheets too much. In fact, they are running much more stable current account balances. Some countries like South Africa are even running current account surpluses rather than deficits.

However, countries including Sri Lanka and Pakistan, which are importers of commodities and were running over-levered balance sheets and too much dollar-denominated debt are going through a restructuring. There is going to be quite a lot of relative value to take advantage of on the higher yielding part of the asset class. But overall, you get massively overcompensated for the risk you're taking as investors here.

My special topic for today is China real estate, because it’s a topic of interest for Robert and the team at Momentum. It’s probably the most distressed sector in emerging markets that I've seen since the beginning of my career. It's hard to see one single sector that is so large and close to 100 companies where the entire sector trades at seven to 20 cents on the dollar, with a few companies trading at 30 to 50 cents on the dollar.

Let's talk about what happened here and why we think there’s an opportunity to pick up some of these highly distressed assets that have a very big upside at this point in time. In a nutshell, the beginning of the crisis came in mid-2020 to mid-2021, when the Chinese government implemented what it called the 'three red lines' policies. This placed three ratios limiting leverage on developers in China, which had been running with very levered balance sheets for some time. In essence, the Chinese government announced it would rein-in this leverage and demand developers improved their cash generation.

While this was arguably a positive measure, to the extent that is encouraged developers to improve their balance sheets, the problem came as a result of Chinese banks and asset management companies over-complying with the regulation. As a result, capital was drained totally out of the sector. And without working capital to keep on building their properties plus a levered balance sheet, companies started experiencing liquidity problems one after the other.

Despite having decent assets to cover the majority of their liabilities in our view, liquidity problems became an overriding concern. In the first half of 2021, we started to see the first defaults, with Evergrande and Fantasia. Towards the end of 2021 and the beginning of 2022, the vast majority of Chinese real estate developers were already in trouble. The final straw that broke the rest of the camels' backs came with the second leg of lockdowns and China maintaining its zero COVID policy strategies. This locked people down in the key financial centres of Shanghai and Beijing, reduced the confidence of the Chinese population, and led to the cancellation of any property purchases. Obviously, this meant the liquidity issue grew even worse.

Throughout this period, the biggest problem was that the central government and the provinces of China did very little to alleviate the acute liquidity crisis impacting the sector. But this has been changing since the second half of 2022. Both central and local governments have been putting funds in place to help developers to finish their properties that were sold but were interrupted during the liquidity crisis, and this is a very important step to rebuilding confidence on the sector. At the same time, the Chinese government guaranteed the issuance for four of the larger, healthier developers, and that has expanded to six developers over the last week.

Finally, some of the provinces like Hunan, where the vast majority of problems in the real estate in terms of sold but not delivered properties yet, announced a fund on its own that will inject liquidity to the construction companies. Considering where China real estate is trading, with single B properties trading at close to 5,000 basis points over Treasury and BB names trading at 4,000 basis points, which are relatively healthier names, real estate is still an extremely important sector for China

Just to give you a statistic which corroborates our thinking, today, about 64% of the Chinese population live in cities, meaning the urbanisation rate is at pretty low levels. If you look at Mongolia, for example, 78% of the population live in cities. In Brazil, 84% of the population live in cities. So as China continues to develop, they're going to incentivise more and more people living to cities. If this 20% gap from China to Brazil closes, we're talking about more than 200 million people moving to cities. Therefore, despite the demographics of China, where the working age population will be declining, the vast majority of this working age population will be also migrating to cities. So, there will be significant demand for real estate.

And from a political viewpoint, this sector is extremely important for China. There's no way China will go through a property crisis similar to what Japan had in the 1980s and 1990s. The Chinese political leadership is taking measures now that show they care about the situation.

So, I would argue this is an opportunity to diversify your portfolios, and get into a sector that is trades with a very low correlation across most other assets. You're buying distressed assets at very cheap valuations. And you're also buying assets that are too important and too big for one of the largest countries in the world to allow to fail. That's my special topic for today. Thank you for your time.

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