We held a series of client meetings in London over the past fortnight, seeing over 20 clients, consisting of a mix of fixed income and equity investors in EM and Frontiers, Africa specialists, and special situations and distress funds. We summarise some of the key discussion points here.
The meetings took place against a challenging global backdrop, amid the Fed’s surprise 75bps policy rate hike on 15 June, triggering a severe market rout and setting a dour tone for EM. However, that didn’t stop investors, or us, looking for chinks of light.
Top-down views
Fixed-income investors, especially long-only funds, were already feeling the pain in a difficult year given the twin external shocks of war and rates, but this only intensified during the June sell-off. The JPM EMBI index had delivered a total return of -17.9% ytd (through to cob 24 June, as per Bloomberg), with the spread widening by 51bps from 6 to 24 June alone to 430bps (bringing the ytd increase to 100bps through 24 June). Two consecutive years of negative EM hard currency bond returns are rare and made the case for EM investing that much harder.
The key question from many investors was whether we’d reached the bottom or if there was more weakness to come. Few investors seemed to have a strong view one way or the other, hoping for the former, but fearing the latter, a testament to the high degree of market uncertainty and volatility. But generally, the bias seemed to be skewed towards further market declines, with the outlook intrinsically tied to the success of monetary authorities, particularly in the Advanced Economies, getting ahead of the global inflation surge. In addition, there were also concerns among some investors over low market liquidity and that positioning could see more pressure on spreads. Nor had we seen sizeable outflows yet.
We also believe there is more pain to come for EM credit (as we wrote at the beginning of last week), noting the apparent paradox that while spreads have widened a bit this year, and are at post-GFC highs (barring the Covid shock and spike in March after Russia’s invasion of Ukraine), the surprise is that they are not even higher given high inflation, high debt, post-Covid scarring, weaker growth and deteriorating debt dynamics, and the end of over a decade of cheap money which isn’t coming back.
However, we also argue that the sell-off had likely unlocked pockets of value among higher-yielding frontier credits, and few investors really disagreed with that premise. On this basis, top picks and absolute value trades were a key focus of nearly all our discussions, for which we highlighted Egypt, Ghana, Kenya, Nigeria, and Pakistan as selling off the most (relative to fundamentals) in our view, and fostering some detailed discussions about recovery values. However, that is not to say that these couldn’t go even lower given a combination of external and domestic conditions.
Still, investors were also concerned about a new round of sovereign defaults – and who would be next; a concern reflected in the IMF’s analysis that says nearly 60% of LICs are either already in, or at high risk of, debt distress. Our own analysis shows that a fifth of the index (by number of countries) is in distress. Hence, while some countries that are trading at or near distressed levels may ultimately weather the crisis, some may not – the most obvious candidates in our view being El Salvador, Tunisia and Pakistan (if it doesn’t get an IMF programme), while Ukraine may also default (albeit for different reasons). And Russia now has too.
This led to some interesting discussions on how feasible it will be for vulnerable countries to plug external financing gaps with alternative financing sources if market access is not restored, the role of the IMF and its views on burden-sharing (would the Fund respond more flexibly to concerns about a new wave of EM sovereign defaults without seeking PSI in order to avoid a wider systemic crisis), and the Common Framework. There was some agreement that the Common Framework has not been successful thus far and that the presence of China and its potential resistance to restructure will continue to be a point of contention and source of delays in future restructurings. However, we argue – given the emergence of different creditor groups – if not the Common Framework, we’d still need something like it, and these same problems would have emerged anyway.
Country specifics
Clients broadly placed countries into four buckets: 1) the valuation plays that have sold off sharply but will likely avoid default and/or have seen bonds fall close to, or below, recovery value; 2) countries that are likely to fall into debt distress if external conditions do not improve and whose valuations have not reached distressed levels; 3) countries already in distress; and 4) countries with resilient fundamentals or idiosyncratic stories. Across these categories, many clients asked about our “top buys” and “top sells”.
On the valuation front (Egypt, Ghana, Kenya, Nigeria and Pakistan) clients seemed most concerned about Pakistan, with worries that it was on track to be “the next Sri Lanka” given worryingly large external imbalances and doubts over its ability to commit to the necessary reforms to stave off a crisis given the difficult political backdrop. Concerns were also elevated for Egypt and Kenya, where there were doubts about their ability to meet continually large GEFR over the medium-term (although with the IMF programme in Kenya and huge GCC inflows in Egypt providing some degree of confidence that a sudden stop was not imminent).
Reassuringly, most investors agreed with our views on Ghana, which we recently upgraded to Buy, purely on valuation, although investors were still sceptical about its ability to deliver fiscal consolidation, especially as the next election approaches, while noting concerns that falling reserves or an FX/inflation spiral could bring forward the timing of a debt crisis. We suspect the market is increasingly coming round to the view that a Ghana default, if not imminent, is becoming more inevitable, which raises the question – asked by virtually everyone with an interest – of when, and at what point, does Ghana go to the IMF, and what will the IMF do?
In Nigeria, investors were focused on parsing whether higher oil prices were good or bad for the country given the decline in production and costly subsidy regime and whether next year’s election would deliver a much-needed policy shift. However, most were generally in accordance with our view that default was not likely in the coming years, despite a rather grim fundamental outlook amid limited prospects for structural reforms and a re-thinking of the government’s broken FX regime in the year ahead.
In the strong fundamentals bucket, or idiosyncratic stories, we highlight Angola, some CFA Franc countries, Mozambique, Rwanda, Uganda and Uzbekistan. We think the best story, with the most value, is Mozambique, on which we have a Buy. Indeed, Mozambique was one of our top picks for 2022 and even though the bonds have now slipped into negative total returns ytd, they have still outperformed the index and are one of the best performers this year. We see Mozambique as a special situation, driven by LNG, and therefore less synchronised with global financial conditions. Clients generally agreed.
We also highlight the CFA Franc zone countries (Benin, Cote d’Ivoire, Senegal) as having good fundamentals, but less compelling value, which helped them come through the pandemic in good shape, although the recent anti-government protests in Senegal ahead of next month’s parliamentary elections raised some questions from clients. We think another country with good fundamentals, at least judged by very high reserves coverage (c50% of GDP), is Uzbekistan, and even yields there have risen to 7-8%.
Clients were less excited about Rwanda and Uganda where there were either concerns about large twin deficits or, where the structural view was positive, on the low liquidity of publicly traded instruments. But interestingly, with elections in August (which will determine whether we have the same or a new president), Angola only came up a few times. Investors agreed with our positive view, based in part on the much-improved debt position, but the lack of debate, or concern, may reflect the expectation that the incumbent MPLA party will win. We wonder if this may make the bonds vulnerable if it does not, especially with so little known about the UNITA opposition.
Meanwhile, the sell-off has also shrunk the list of countries to avoid, notwithstanding concerns over further generalised market declines, with Sri Lanka upgraded from Sell to Hold in April as they prepared to enter default, Tunisia upgraded from Sell to Hold at the beginning of the roadshow as bonds approached our estimate of recovery value, and Pakistan and Ghana both vulnerable but with Buy recommendations on a valuation basis (with bonds trading roughly in line with recovery value for both countries).
El Salvador, despite its low prices, in the 30s beyond the ‘23s, however still falls in this camp for us, given uncertainty over the January maturity – with the market-implied probability of default at some 50:50. But even if it is paid (presumably through unconventional means), it was hard to have much confidence over the rest of the bonds, as the policy and political context would seem to preclude IMF assistance. Investors agreed. We also added Colombia to the mix, with a Sell following the election of leftist Gustavo Petro in the presidential run-off on 19 June, although this was of less interest to European-based clients.
Most investors agreed with our view that the restructuring was likely to be prolonged and difficult in Sri Lanka, and that the economic situation is likely to get worse before it gets better, with few seemingly prepared to enter the trade despite bonds being near the lower end of our estimated recovery value range (in accordance with our Hold recommendation). Likewise, few investors seemed willing to stick their necks out on Tunisia, with many in the earlier stages of their due diligence on the country.
In the distressed camp, there were surprisingly few questions on Ethiopia and Zambia, which dominated the conversations in September, as clients seemed resigned to wait for the Common Framework to slowly play itself out and as the conflict rages on in Ethiopia. That said, with the Ethiopia ‘24s falling sharply to cUS$57 from cUS$77 in February and the Zambia ‘24s falling to cUS$62 from cUS$82 in November to cUS$76 in April (in line with our Sell recommendation, albeit for different reasons than we thought), investors may start wondering if we have reached an attractive entry point (with the Zambia ‘24s now trading roughly in line with our estimated recovery value from last August).
Ukraine came up a number of times, although there were more questions than answers, with little certainty over how long the war will last (with a strong bias for longer than any chance of it finishing soon), what Ukraine will look like then, and prospects for recovery values (albeit with an expectation of a massive amount of financing being provided for post-war reconstruction), although most investors are by now surprised that Kyiv has remained current for so long and hasn’t defaulted already. As such, from a trading perspective, views on the September maturity were one focus of investors.
Interestingly, Argentina produced more interest than we had expected, after prices fell into the 20s, with investors testing the idea that this had surely created an attractive entry point, although even then we think investors were pretty divided on the issue. Some saw merit in this argument, while for others, Argentina was uninvestable.
Along similar lines, with prices now in single figures, Lebanon also piqued interest but there was little confidence on potential recovery values and agreement that it was likely going to be a long and complicated process.