emerging markets debt · emerging markets debt balancing risks with yield potential february 2017...

Emerging Markets Debt

Balancing risks with yield potential

February 2017

Authored by:

Nishant Upadhyay, Head of Global Emerging Markets Debt

Binqi Liu, Senior Portfolio Manager, Emerging Markets Debt

Amanda La Marca, Senior Global Emerging Markets Debt Product Specialist

This publication is intended for Professional Clients

only and should not be distributed to or relied upon

by Retail Clients. The information contained in this

publication is not intended as investment advice

or recommendation. Non contractual document.

2 Non contractual document

EMD: Balancing risks with yield potential

Introduction 2

Trumponomics: A reality check 3

Rationalizing the US rate hikes 6

Relative value within EMD 9

Conclusion 12

Introduction

Emerging markets debt (EMD) posted impressive returns in 2016 in both

external debt (+10.19% JPM EMBIG) and local debt (+9.94% JPM GBI-EM GD),

driven by several factors: the recovery in oil, low developed market (DM) yields

and risk-driven flows into the asset class. Through October 2016, emerging

markets (EM) rallied by 13.35% in hard currency (JPM EMBIG) and 16.08% in

local debt (JPM GBI-EM GD). However, the November US election stalled the

rally given the negative impact Trump’s protectionist and anti-trade rhetoric

would have on EM countries. As a result, EMD assets experienced a spike in

volatility in the aftermath of the Trump victory and flows to the asset class

reversed with approximately $15 billion of outflows through the end of the year.

Looking ahead to 2017, uncertainty surrounding the Trump administration and

the future path of US interest rates will likely result in elevated levels of volatility

in EMD over the course of the year. While this volatility should warrant caution in

certain segments of the asset class, it also has the potential to create pockets of

opportunity. In this article, we will discuss the areas where we think there may be

attractive opportunities in EMD and where there are possible risks. It is important

to put these risks into perspective when accounting for the attractive yields in the

asset class to see that there is potential to generate positive returns despite the

future risks including higher US interest rates.


EMD: Balancing risks with yield potentialTrumponomics: A reality check

A key topic of discussion for 2017 is the potential implications of the Trump

presidency and what that means for EM countries. While Trump’s campaign

focused on anti-trade and protectionist views, considerable uncertainty is

surrounding the transition of his rhetoric to implemented policies. Let’s examine

the potential impact of some early promises.

Infrastructure build out

Trump has promised large infrastructure spending and tax cuts to promote US

GDP growth. However, achieving both of these goals would require a form of

deficit financing that goes against the historical views of the Republican

Congress. If the infrastructure spending agenda does become a reality, the

question then becomes the timeframe. If the spending is planned over a longer

time horizon, the benefit to the US economy would clearly be lessened in the

short- to medium-term. Another factor that may impact the potential benefit of

the infrastructure spending is that these programs take time to plan and execute.

While the market has already priced in the positive effect of the increased

spending as a stimulus for US growth, there may be market disappointment if

this agenda gets hijacked by delays or is planned over ten or more years.

In the context of EM, it is important to highlight the positive impact US

infrastructure spending could have on markets. The US would likely have to find

external resources for the commodity-intensive infrastructure build out as most

commodities are not produced in the US, apart from energy, which could benefit

EM economies.

Protectionist views

Trump’s protectionist rhetoric has been rather confrontational towards large EM

trading partners, such as China and Mexico, and has included threats to

implement large tariffs on imports. However, some of the largest trade partners

of the US also represent its largest creditors. Imposing a 35-45% tax barrier on

them will be difficult in an environment where the US may issue more debt to

support infrastructure spending

In the context of

EM, it is important

to highlight the

positive impact US

infrastructure

spending could

have on markets

The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the

markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global

Asset Management. Consequently, HSBC Global Asset Management will not be held responsible for any investment or

non-investment decision taken on the basis of the commentary and/or analysis in this document.



Anti-trade rhetoric

If anti-trade sentiment becomes reality, it is critical to quantify its potential impact

on EM countries. To do this, we can start by looking at the size of the US as a

buyer of exports from EM countries. With the exception of Mexico, exports to the

US contribute a small percentage to the GDP of individual EM countries (Figure

1). When looking at Mexico, remember that trade is a two-way street and that

Mexico imports from the US as well. Mexico plays a key role in the US value

chain, especially in the automobile industry. It would take years for many US

corporations to rethink and implement alternative strategies for shifting elements

of the complex value chain embedded in Mexico. Certainly future foreign direct

investment (FDI) to Mexico may be impacted, but that will not undo the large

flows they have received over the past 10+ years.

Source: HSBC Global Asset Management, Bloomberg as of December 2016.

Figure 1: Export to the US in terms of GDP percentage

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0%

5%

10%

15%

20%

25%

30%

Export to US/GDP % Export/GDP % (rhs)






0,0%

0,0%

0,0%

0,1%

0,1%

0,1%

0,2%

0,2%

0,3%

0,4%

0,5%

0,5%

0,6%

0,6%

0,8%

1,0%

1,0%

1,3%

1,4%

3,1%

Kazakhstan

Ukraine

Poland

Indonesia

Hungary

Peru

Turkey

China

Philippines

Russia

South Africa

Malaysia

Argentina

Lebanon

Colombia

Venezuela

Chile

Brazil

Panama

Mexico

US FDI as % of GDP - Top 20 EM countries in EMBIG


If we dig a bit further into FDI, we see that, as an investor, the US has limited

impact on EM countries: the top 13 countries receiving US FDI are DM countries

(Figure 2). Mexico is the top ranking EM country at 15th on the list with $36

billion. While this may seem high, when we look at what the $36 billion actually

represents, we see that it only accounts for 3% of Mexico’s GDP. Overall, the US

invests only a limited amount in EM economies, so the potential effect of stricter

US trade policy on EM countries may be less than the market is anticipating.

Source: HSBC Global Asset Management, Bloomberg as of December 7, 2016.

Figure 2: Distribution of US FDI

15

15

18

21

24

25

27

28

30

31

36

38

43

45

47

51

61

137

144

201

251

319

342

414

569

Hong Kong

Luxembourg

Other

China

Brazil

Israel

UAE

Bermuda

Norway

Singapore

Mexico

Korea,…

Belgium

Australia

Italy

Sweden

Spain

Netherlands

Switzerland

Ireland

France

Germany

Canada

Japan

UK

Top 20 US FDI destinations (US$ bn)





Korea


-4

-2

0

2

4

6

8

Perc

ent (%

)

US Nominal GDP Growth yoy (%) UST 10y Yield

Many investors have voiced concerns about the pressures of rising US Treasury

rates on EM countries. US 10-year Treasury yields rose sharply in the last two

months of 2016 and ended the year at 2.44%. Given the inflationary measures

proposed by Trump, these yields are likely to continue increasing going forward.

But how much further can rates rise in the near-term? While this depends on US

GDP growth and inflation rates, putting things in perspective can help better

understand the trajectory.

Learning from history

Over the past 6-7 years, US nominal GDP has ranged between 2.5% and 5.0%,

while the yield on US 10-year Treasuries has ranged between 1.5% and 3.5%.

We believe if US GDP growth were to rise toward the upper bounds of this range

over the next few years, which is a distinct possibility, there is a strong likelihood

that the US 10-year Treasury yield would also increase to the upper band of its

range to 3.5%. While this would mean a 100 basis point (bps) increase from

today’s levels, it is still far lower than the 4.5-5.5% that some market participants

are citing. To put this fear into historical context, 4.5-5.5% 10-year Treasury

yields are higher than the yields seen in the early 2000’s, when US nominal GDP

growth was at 7% and the country was at the peak of its housing boom. We

believe that, given this historic range, there is limited potential for US Treasury

yields to blow out; instead, we think, over the next three years, 10-year yields are

likely to stay within more recent norms, between 2-4%.


EMD: Balancing risks with yield potentialRationalizing the US rate hikes

Figure 3: US GDP growth and US Treasury Yields have been closely tied

We think, over the

next three years,

10-year US

Treasury yields are

likely to stay within

more recent norms,

between 2-4%.






Local Debt - Annualized 3-Year returns

Scenario analysis – EM local debt returns versus DM returns

bp change Germany Japan US EM Local

-100 4.78 3.54 6.25 9.97

-50 3.20 1.95 4.79 9.16

-25 2.41 1.15 4.07 8.76

0 1.61 0.35 3.34 8.35

25 0.82 -0.44 2.61 7.94

50 0.03 -1.24 1.89 7.54

100 -1.55 -2.84 0.43 6.72

150 -3.14 -4.43 -1.02 5.91

200 -4.72 -6.02 -2.48 5.10


EMD in a rising rate environment

Though it is true that a rise in US Treasury yields will have a negative impact on EMD, we feel the degree of the

impact may not be as drastic as some imagine. We have conducted numerous scenario analyses for both EM

local debt and EM hard currency debt to determine the potential impact of US rate hikes on each asset class and

to help determine returns EMD investors can expect to achieve over the next few years.

Let’s begin with EM local debt. We evaluated the annualized 3-year return for the EM local debt index (JPM GBI-

EM GD) under various scenarios of rate increases, from 100 bps cuts to 200 bps hikes (left column of Figure 5),

in DM countries. We also assumed -50 bps of yield compression for the EM local index because the current gap

between the yields of EM and G3 is at historic peaks and there is a likelihood for some retracement. Applying

the assumptions that DM overnight interest rates were to rise by 100 bps over the next three years and the yield

index were to compress by 50 bps, EM local debt would achieve an annualized return of 6.72% (see red box in

Figure 5). In contrast, Germany and Japan would experience negative returns and the US would have close to

flat returns. Furthermore, this scenario analysis does not take into account EM local currencies, which, with

today’s extremely cheap valuations, could provide an additional boost to EM local debt returns.

Source: HSBC Global Asset Management, Bloomberg of January 17, 2017.

Figure 5: EM vs DM historical yields

Source: HSBC Global Asset Management, Bloomberg of January 2017.

-

2

4

6

8

10

Yiel

d (

%)

G-3 blended rate Difference EM local yield





The performance figures displayed in the document relate to the past and past performance should not be seen as an

indication of future returns.


Hard Currency - Annualized 3-Year returns

bp change Germany Japan USEM Hard

Currency

-100 4.78 3.54 6.25 8.99

-50 3.20 1.95 4.79 7.90

-25 2.41 1.15 4.07 7.36

0 1.61 0.35 3.34 6.81

25 0.82 -0.44 2.61 6.27

50 0.03 -1.24 1.89 5.73

100 -1.55 -2.84 0.43 4.64

150 -3.14 -4.43 -1.02 3.55

200 -4.72 -6.02 -2.48 2.47


Our analysis showed, assuming a 100 bps rise in DM overnight rates over the

next three years, EM hard currency debt would deliver a potential 3-year

annualized return of 4.64% (see red box in Figure 6). So, even if US Treasury

yields continued to rise over the next 3-years, the asset class could still

potentially deliver attractive relative returns as the current level of EM yields

provide a substantial cushion against US rate hikes. Even in the worst case

scenario, if EM hard currency spreads increased by 100 basis points, the JPM

EMBIG index could still potentially post a positive annualized 3-year return of

2.67%.

Figure 6: Scenario analysis – EM hard currency returns versus DM returns

We performed a similar exercise with the EMD hard currency index (JPM

EMBIG). We analyzed its potential annualized 3-year returns versus a range of

DM 10-year bonds, assuming no spread changes to the index.

Source: HSBC Global Asset Management, Bloomberg of January 2017.





The performance figures displayed in the document relate to the past and past performance should not be seen as an

indication of future returns.


EMD: Balancing risks with yield potentialRelative value within EMD

EMD valuations have shifted with the recent spike in volatility and heightened

investor sensitivity to risk in the asset class. In some cases, we see compelling

investment opportunities, whereas, in others, we think prices look expensive in

terms of the future risks ahead. Here we examine valuations across three main

EMD segments: hard currency debt, local rates and local currencies.

Hard Currency Debt

Following the US election, EM hard currency index spreads widened by more

than 50bps (JPM EMBIG) but have since retraced back to the tight levels seen

prior the election.

Figure 7: EM Hard Currency Spreads (JPM EMBIG)

Source: HSBC Global Asset Management, Bloomberg of December 2016.

As a result, hard currency spread levels do not appear cheap. However, it is

important to view these spread levels in a wider EM context. First, it should be

noted that tighter spread levels may be somewhat warranted given the improved

fundamental picture in many EM countries. For many EM countries with floating

currency exchange rate regimes, the significant drop in commodity prices over

the last few years resulted in weaker currency levels and sharp falls in their

respective terms of trade. As a result of the weaker currencies, the terms of trade

have begun to stabilize and, in many cases, current account balances are

starting to improve. The second point of note is that while spreads today may not

appear attractive compared to historic levels, EM spreads are trading at a

significant premium to DM assets, especially in the investment grade sector. The

spread differential should contribute to demand for EMD assets going forward.

240

290

340

390

440

490

540

Spre

ad L

evel (B

ps)

Tapering

Decline in Oil Prices

Oil Rebound

Trump

Inflows into Riskier Assets

The spread

differential

between EM and

DM should

contribute to

demand for EMD

assets going

forward.







Local Rates

Following the post-election sell-off in November, we have become increasingly

positive on EM local rates as we believe there are pockets of opportunity despite

the potential for further US interest rate hikes.

As seen in Figure 8, several EM countries have hiked rates significantly (dark

blue bars) since the 2013 taper tantrum, and, in many cases, market participants

are anticipating rates increasing even further over the next year (light bars). For

example, Mexico has increased policy rates by close to 200 bps since 2013 and

the market is pricing in further hikes over the next year due to the Fed’s agenda

to continue increasing rates. In contrast, the market is expecting rate cuts in

Brazil, Colombia and Russia in the next year.

Figure 8: Global policy rate movements

Source: HSBC Global Asset Management, Bloomberg as of December 2016.

We combined the interest rate movements that have already taken place with

what is priced in over the next twelve months to evaluate the value potential

across the different EM countries (gray line). Based on this, we believe there are

attractive valuations in many EM countries purely from a rate perspective as the

bond prices have cheapened in countries like Turkey and Brazil. On the other

hand, there are also some countries that appear expensive. Hungary, for

instance, has experienced over 300 bps of rate cuts so yields have compressed

and there is no expectation for future hikes. As we can see, in the EMD local rate

segment, investors must understand and monitor relative value positions.

-600

-400

-200

0

200

400

600

800

Polic

y R

ate

Change (

bps)

Policy rate change since 12/31/2012 Policy rate change priced in 1 year Sum

There are attractive

valuations in many

EM countries

purely from a rate

perspective as the

bond prices have

cheapened







Local Currency

Select EM currencies have cheapened meaningfully over the past few years in

terms of the real effective exchange rates (REER)1 versus their 5-year average

(horizontal axis) resulting in attractive valuations. In addition, these currencies

offer high levels of carry2 in many cases (vertical axis).

Figure 9: Valuations of EM local currencies


We think these EM currencies, such as the Brazilian real, Turkish lira and

Russian ruble (circled in the upper left of Figure 9) have represented particularly

compelling opportunities over the past year. In addition to attractive valuations

and high yields, the sharp depreciation in these currencies has translated into an

improving fundamental picture in select countries as we see trade balances and

current accounts stabilizing and, in some cases, improving.

In the other circle, we identified currencies that have not adjusted over this same

period and, as a result, valuations remain expensive. Many of these expensive

currencies also offer very low yield and, in some cases, negative carry. Most of

these currencies are Asian and Eastern European currencies where we hold

underweight positions in our portfolios. Similar to local rates, the theme of

relative value is critical in evaluating local currencies.

1The real effective exchange rate: the weighted average of a country's currency relative to an index or basket of

other major currencies, adjusted for the effects of inflation.

2Carry refers to the implied money market rate earned on a long currency position.

We think these EM

currencies, such as

the Brazilian real,

Turkish lira and

Russian ruble have

represented

particularly

compelling

opportunities over

the past year

TRY

BRL

RUB

ZARCOP

MXNIDR INRCNY

PEN

CLP

MYRPHP

PLN THBSGD KRW

RONHUF ILS TWD-2%

0%

2%

4%

6%

8%

10%

12%

-35,0% -30,0% -25,0% -20,0% -15,0% -10,0% -5,0% 0,0% 5,0%

Carr

y

5y REER Adjustment






EMD: Balancing risks with yield potentialConclusion

Following the presidential election in the US, the landscape for EM countries has

been altered due to uncertainty surrounding US policies and their implications on

EM countries. Adding to these risks is the future path of US Treasury yields if

Trump’s policies do in fact lead to stronger US growth and inflation. Other

important risks for EMD include the elections across Europe, muted demand for

oil, as well as elections in key EM countries.

While these risk factors and further US interest rate hikes heighten market

uncertainty and potential volatility for EMD in 2017, the attractive yields offered

by EMD assets compared to DM assets can absorb some of the impact of these

risks. As seen in our scenario analyses, even in a rising rate environment, EM

hard currency and local debt asset classes could provide positive annualized

returns over the next three years.

As we manage our portfolios in the upcoming year, we will focus on determining

how EM countries will perform in this rising rate environment and which

segments of the asset class have the potential to outperform. With a multitude of

risks and uncertainties facing EMD, tactical trading and active management is

required when investing in the asset class to identify attractive opportunities in

areas that have repriced and offer more attractive valuations and to take a

cautious view towards areas that have not adjusted and appear expensive.





Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset

Management accepts no liability for any failure to meet such forecast, projection or target.


Authors?

Nishant Upadhyay

Head of Global Emerging Markets Debt

Mr. Upadhyay, as Head of the Global Emerging Markets Debt team, is responsible

for the Global Emerging Markets Debt portfolios. He joined the team in September

2015 from PIMCO where he was an emerging markets and global credit portfolio

manager for nine years. During his time at PIMCO, Mr. Upadhyay spent time as an

Associate to PIMCO’s Global Bond portfolio management team with exposure to

rates and currency products before managing emerging markets debt portfolios

and diversified income portfolios (hybrids of EMD and credit). Prior to joining the

firm, Mr. Upadhyay held positions at Citibank and ABN AMRO Bank and has been

working in the financial industry since 2000. Mr. Upadhyay has a Bachelor of

Science from the Hindu College, Delhi University (India) and a MBA from the

Indian Institute of Management, Indore, India.

Binqi Liu

Senior Portfolio Manager

Mrs. Liu is a senior portfolio manager for the Global Emerging Markets Debt team.

She joined the firm as an analyst in June 2008 focusing on sovereign analysis and

local markets developing the team's country credit and currency valuation models.

Mrs. Liu became a portfolio manager in January 2011 when she was pointed as

Co-portfolio manager for our flagship local funds. Mrs. Liu was relocated to HSBC

Global Asset Management UK in February 2015, taking time zone and geographic

advantage of research and trading hours, as well as broader support of global fixed

income platform in London. Besides her role as a portfolio manager, Mrs. Liu

currently also serves as the economist of the Global Emerging Markets Debt team,

responsible for global macro and sovereign economic research for both local and

external markets. Before joining the firm, she worked as a research assistant for

Robert A. Mundell, Nobel Prize winner in Economics, June 2007. Mrs. Liu has a

B.A. from Hunan University in China and an M.P.A. from Columbia University. Mrs.

Liu is fluent in Mandarin and Cantonese.

Amanda J. La Marca

Senior Global Emerging Markets Debt Product Specialist

Ms. La Marca is a senior product specialist for the Global Emerging Markets Debt

capabilities. Prior to her current role, Ms. La Marca was a client service specialist

for HSBC Global Asset Management, responsible for servicing US-based client

accounts across various fixed income products. Before joining HSBC in April 2008,

she worked for PricewaterhouseCoopers LLP. in the systems and process

assurance division. Ms. La Marca has been working in the industry since 2006.

She holds a BS from the University of Maryland.


Important information?

Firm Disclosure

This publication is distributed by HSBC Global Asset Management (France) and is only intended for professional investors as

defined by MiFID. It is incomplete without the oral briefing provided by the representatives of HSBC Global Asset Management

(France). The information contained herein is subject to change without notice. All non-authorised reproduction or use of this

commentary and analysis will be the responsibility of the user and will be likely to lead to legal proceedings. This document has

no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any

financial instrument in any jurisdiction in which such an offer is not lawful.


markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset

Management (France).Consequently, HSBC Global Asset Management (France) will not be held responsible for any investment

or disinvestment decision taken on the basis of the commentary and/or analysis in this document. All data from HSBC Global

Asset Management unless otherwise specified. Any third party information has been obtained from sources we believe to be

reliable, but which we have not independently verified.

The performance figures displayed in the document relate to the past and past performance should not be seen as an indication

of future returns. The value of investments and any income from them can go down as well as up. Capital is not guaranteed.

Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in established

markets. Investors are reminded that investments in High Yield issues represent a higher risk of default compared to Investment

Grade issues. Investments in Credit Default Swaps (CDS) are less liquid than standard bond issues. Fluctuations in the rate of

exchange of currencies may have a significant impact on performance. Investment in Financial Derivative Instruments (FDI) may

result in losses in excess of the amount invested. This is because a small movement in the price of the underlying financial

instrument may result in a substantial movement in the price of the FDI. The strategies can invest in sub investment grade bonds,

which may produce a higher level of income than investment grade bonds, but carry increased risk of default on repayment. The

value of the underlying assets are strongly affected by interest rate fluctuations and by changes in the credit ratings of the

underlying issuer of the assets.

Important information for Luxembourg investors: HSBC entities in Luxembourg are regulated and authorised by the Commission

de Surveillance du Secteur Financier (CSSF).

Important information for Swiss investors: This publication is intended exclusively towards qualified investors in the meaning of

Art. 10 para 3, 3bis and 3ter of the Federal Collective Investment Schemes Act (CISA).

HSBC Global Asset Management is the brand name for the asset management business of HSBC Group. The above document

has been produced by HSBC Global Asset Management (France) and has been approved for distribution/issue by the following

entities :

HSBC Global Asset Management (France)

HSBC Global Asset Management (France) - 421 345 489 RCS Nanterre. Portfolio management company authorised by the

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Copyright © 2017. HSBC Global Asset Management (France). All rights reserved.

Non contractual document updated in February 2017 - AMFR_Ext_112_2017

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