Friday 29 Mar 2024
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly on March 25, 2019 - March 31, 2019

Investors should keep a close watch on China’s slowing economic growth as it could present a key risk to the performance of emerging market (EM) bonds, says Abbas Ameli-Renani, EM debt portfolio manager at Amundi Asset Management in London.

The Chinese government has found it challenging to stimulate the country’s economy today compared with three years ago, when commodity prices plunged and took a toll on the economy, he adds. “The market is expecting China to grow at 6% to 6.5% this year. If it falls below 6%, it will be hard for the market to stomach.”

Ameli-Renani says China’s fiscal stimulus has been less efficient over the years. The properties, roads, bridges and airports built using the previous round of stimulus have not been utilised. Also, the capital injection has created zombie firms that are being kept alive mainly due to government funding.

While China could implement other fiscal stimulus measures such as cutting personal income tax and value-added tax further to boost economic growth, it could cause the current account balance to slip into a deficit. According to the Caixin Global Report, China’s current account balance stood at 0.39% of GDP last year.

“Further tax cuts would encourage private consumption and investment. It would also mean the import of more capital goods. We will not be surprised to see a current account deficit if they keep stimulating the economy this way,” says Ameli-Renani.

China’s shrinking current account surplus means that the People’s Bank of China (PBoC) would not be able to lower interest rates as freely as before. “In 2016, the PBoC lowered its rate and it triggered capital outflows as investors could get higher returns abroad. However, that was partly cushioned by having a current account surplus and its currency did not face too much pressure,” says Ameli-Renani.

“Last year’s current account balance was near zero. If the interest rate differential between China and the US widens, there will be no surplus to offset that.”

In the past, the Chinese government could allow the renminbi to weaken and boost exports. But it is unable to do so today as it is facing external pressure from the US to not “manipulate” its currency.

All these, coupled with the private sector debt-to-GDP ratio of more than 150%, are the reasons investors should keep an eye on China’s economic growth this year.

 

EM debt expected to deliver single-digit returns

Ameli-Renani expects EM bonds to generate healthy single-digit returns for investors this year under a more favourable global economic environment. Global fund flows that have been returning to EM bonds since the start of 2019 seem to support his outlook for the asset class.

“There have been about US$20 billion of inflows into emerging markets in the first 10 weeks of the year. That is already more than the entire amount of inflows in 2018,” says Ameli-Renani.

He anticipates funds to continue flowing into EM bonds as the US-China trade tensions ease and major central banks turn dovish. He says investors are likely to see a deal being struck between the US and China in the next few weeks as US President Donald Trump’s position to negotiate with China has weakened.

“Last year, we saw Trump up the ante against China. That was because the US economy and stock market were outperforming [other countries] due to the tax cut announced in 2017,” says Ameli-Renani.

“However, the US stock markets plunged in the fourth quarter [as investors were worried about the state of the economy] and that changed things. It was a reminder to the political actors in the US, including Trump, that its economy cannot decouple from the world economy and that it is also vulnerable to the ongoing trade negotiations.

“At this juncture, where the US is already in election mode for 2020, Trump very much needs a deal with China. He may realise that it is no longer a win-lose situation like before. It is either a win-win or a lose-lose.”

On the other hand, major central banks such as the US Federal Reserve and European Central Bank have turned dovish this year in response to the slower global growth. The Bank of Japan is expected to follow suit.

Ameli-Renani expects the Fed — the only major central bank to have embarked on an interest rate normalisation path so far — to not hike rates more than once this year. This is largely due to the performance of the US stock market, which plunged at the end of last year, and expectations of slowing economic growth in the US. “These two developments are supportive of EM assets,” he says.

 

Favours sovereign bonds of South Africa, Indonesia, India

From a tactical point of view, Ameli-Renani favours the local currency bonds of India, Indonesia and South Africa as they are relatively cheap now due to the political uncertainties in those countries.

He says the markets have priced in a lot of risk in South Africa’s local currency bonds due to the country’s upcoming general election on May 8. Investors are concerned that the African National Congress (ANC) — the country’s governing political party that has won every general election since 1994 — could win a healthy majority at the next election under the leadership of President Cyril Ramaphosa.

Investors are also worried that the downgrading of South Africa’s sovereign bonds to sub-investment grade may exclude them from the World Government Bond Index. This could result in a global sell-off amounting to US$6 billion to US$10 billion.

Nevetheless, Ameli-Renani expects the ANC to win the general election. “The party has been in power since the fall of Apartheid and all opinion polls suggest that it will continue to be the biggest party after the next election. Ramaphosa is expected to remain as president,” he says.

He also expects Moody’s to change the country’s sovereign bond outlook from “stable” to “negative” this year, instead of downgrading it. “South Africa now has a Baa3 rating [one notch above sub-investment grade], with a stable outlook. I think the worst-case scenario is that its outlook changes from ‘stable’ to ‘negative’. Our base case is for the rating agency to give the government time to move forward with the restructuring of its state-owned enterprises.”

Ameli-Renani favours the local currency sovereign bonds of Indonesia and India as they are currently undervalued due to their upcoming general elections. On Indonesia, he expects Joko Widodo to be re-elected as president at the polls on April 17.

“We think his chance of winning is very high and his re-election as president will be positive for the market. Widodo has been very successful in carrying out fiscal reforms and delivering high economic growth,” he says.

“Indonesia’s growth outlook is positive and inflation is very well anchored by a tight monetary policy. While its current account deficit is quite high at about 3% of GDP, the macroeconomic conditions are positive for the country.”

As for India, he favours the local currency bonds from a valuation perspective. Prices are cheap and the rupee has been a laggard compared with many of the other EM currencies.

“In India, a lot of pessimism is priced in by the market. The market is very worried about the upcoming general election, about whether the incumbent will be able to regain the majority. I agree that the possibility is high, but the rupee has significantly underperformed the rest of the market in the past few quarters,” says Ameli-Renani.

“The market has already underweight the rupee. If Prime Minister Narendra Modi loses the election, the selloff that could arise from the outcome is limited. However, if Modi wins, we could see quite a sharp rally in the currency.”

However, emerging-market hard-currency bonds will still be the safe and a relatively attractive bet for most individual investors, he says. “It is an asset class in which we have a high conviction view over the medium term. Prices are cheap relative to their developed-market counterparts while their fundamentals are improving both in terms of the fiscal and current account balances. The risk of default, which is a key concern for investors, is also not high in most of the EMs.”

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