2010 was a transformational year for emerging markets (EM). We saw EM sovereign debt spreads trade inside spreads of some developed markets "“ a strong indication that investors are recognizing promising fundamentals in leading emerging economies, even as certain developed nations face financial difficulties, especially fiscal and banking distress in peripheral Europe.
The story of debt of EM corporations was equally compelling in 2010. And we expect EM corporates to continue to be a major growth story and source of opportunity for investors in the years ahead.
Select emerging market corporates have experienced improved underlying business and cashflow fundamentals, including gradual deleveraging over the last several years, as measured by more than 100 names in J.P. Morgan's Corporate Emerging Market Bond Index (CEMBI). And emerging markets appear poised for robust economic growth this year, following strong performance in 2010. The International Monetary Fund notes emerging economies expanded by 7.1% in real terms last year.
EM credit spreads were in full recovery mode in 2010 and we expect credit markets to remain favorable in 2011 (see Figure 1).
Most EM corporate spreads rallied in Q12010 before widening sharply in May with the Greek episode. Thereafter, EM corporate spreads drifted sideways before a recent sell-off related mainly to European debt concerns. Despite this, EM corporates performed strongly in 2010 as compared to EM sovereigns and U.S. corporates rated BBB (see Figure 2).
With EM corporates deepening in size, currently at a total debt stock of $709 billion (as of 2010 YE), up 17% from $605 billion at the end of 2009, and attracting more investor interest, we expect flows to strengthen this year as well as strong demand to absorb the supply of new issues (see Figure 3). Global investors already appear to be getting the message about EMs. From the start of 2010 alone, nearly $75 billion have flowed into EM bonds, according to JPM data.
We expect the EM economic growth story to continue to display strong signs over the cyclical (six- to 12-month) and secular (three- to five-year) horizons, with the potential for substantial growth in private consumption. This implies that domestically driven economies such as Brazil, India and Indonesia could see strong growth in 2011. Several EM consumers have benefited from a sharp job market recovery, as well as a positive wealth effect. Figure 4 shows that private consumption as a percentage of GDP still has room to grow comparing emerging markets (EM) to developed markets (DM).
Potential EM StrengthsPIMCO focuses on entities involved in economic sectors deemed of critical importance to EM countries, such as energy, transport, telecom, policy housing, banking, and water and sewage. In certain cases, such entities address a structural shortage that the government has identified as critical to the maintenance of financial, social or political stability within a country. These sectors are structural elements of every economy allowing for the production of goods and services, enabling mobility of labor and reducing time and costs of production and delivery of products to the market. Telecom facilitates communication. Roads are needed to transport raw materials and finished goods. Factories need a reliable source of energy in order to maximize capacity.
To be sure, emerging markets are not without some volatility, not all credits are created equal, and even "good" credits may not be immune to major geopolitical events.
Still, leverage metrics of several EM corporates have been improving and generally show better ratios and relative value than some corporates in developed markets, as seen in Figures 5 and 6. In general, EM corporates have experienced healthy corporate profits; positive cashflows; low cost structures; and manageable debt profiles, as measured by more than 100 companies in the CEMBI. The growing links between China and several EM countries such as Brazil and Russia have helped sustain export growth for those countries, reduce the cost of capital and sustain the macroeconomic framework.
The good news for investors is that markets "“ and the ratings agencies "“ haven't caught up to this improving fundamental story; in other words, we believe the current ratings in select EM corporate credits do not reflect their "real fundamental" ratings. This sometimes occurs due to rating agencies taking longer to update a credit rating profile or due to corporate ratings generally being capped at the EM sovereign rating (see Figure 6). Adding exposure to EM bonds can help shield dollar-based investors against increases in market interest rates in the United States, in exchange for taking high-quality EM credit risk.
This is another way of saying that we view select EM corporates as "safe spread" "“ defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios and offer a potentially attractive yield. For example, Figure 6 shows the spread over swaps on the CEMBI is currently 49% of the yield to maturity, well above the pre-crisis level, which has been around 20%.
On balance, PIMCO believes that strong credit profiles of several EM countries (i.e., healthy current account balances, rising reserves, low debt levels) coupled with prudent fiscal and monetary management will support continued economic growth that will benefit EM corporates. This brings us to a multi-speed world as described in our cyclical forum in which PIMCO differentiates countries/regions with strong growth from those economies with weak growth (i.e., peripheral Europe).
Sectors We LikeLooking ahead, industries in EM that present potentially attractive valuations on a risk-adjusted basis include oil and gas, utilities, metal and mining, and banks. For EM nations to nurture the domestic demand needed to continue economic growth, they will have to invest in the aforementioned sectors, which are structural elements of every economy allowing for the production of goods and services, enabling mobility of labor and reducing time and costs of production and delivery of products to the market.
As commented earlier, we believe the following industries on a risk-adjusted basis are attractive from a relative value perspective and are positioned to benefit from this multi-speed world.
A. Metal and Mining:In 2010, we saw a clear shift in value and margins away from steel producers (mostly non-integrated, Western producers) to raw material producers (such as iron ore) "“ average steel EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) margins have been around 10% versus raw material margins in excess of 50%. Supply and demand fundamentals were primary drivers for high raw material prices in 2010 compared to 2009 with China providing the demand pull and limited supply (especially in copper), giving pricing power to producers.
Overall earnings generation remained intact, with solid coal demand from EM Asia, stable pricing and low production cost more than offsetting the temporary impact from unfavorable weather. We have noticed larger, global miners increase their capital expenditure (capex) budgets for the next three to five years materially to invest in metals where supply is very limited or where China is a net importer.
For the 2011 outlook, we continue to expect commodity prices to remain at high levels. We expect EM companies to further increase capex and look to acquire assets. Demand from EMs, especially China, remains key. We anticipate China will import more iron ore and coking coal from Brazil and Australia as domestic production falls and quality of ore declines.
Finally, we favor iron ore producers amongst the miners and steel producers as their primary competitive advantage resides in a fully integrated business model with captive iron ore reserves, ownership of a fully developed transportation infrastructure, self-sufficiency in energy generation (60% of total requirement), low cost structure, proximity to domestic steel consuming regions and strong balance sheets.
B. Banks:Our stable view of the EM banking sector's fundamentals in 2010 is related to the (1) strong cyclical tailwinds with improving fundamentals, (2) long-term structural growth for banks, (3) low banking/financial sector penetration, (4) reduction of informality (i.e., less tax avoidance by companies/individuals and a greater use of the financial system) and (5) strong capitalization with no significant impact from changes to international financial requirements, known as Basel III. In general, regulation significantly improved in the last decade, and the sector's balance sheets appear conservative in light of historical volatility.
For the 2011 outlook, we expect balance sheet liquidity to remain healthy through 2011. We remain constructive on EM banks and see the most attractive opportunities in the senior level of the capital structure, selectively taking advantage of the expected large issuance calendar through 2011. We expect EM banks to issue in the range of $60 billion to $80 billion in bonds this year, with supply driven by three factors: balance sheet expansion from loan growth, funding diversification and selected needs for foreign currency.
Yet, we believe that although LT2 (Lower Tier 2) and T1 (Tier 1) capital levels are generally rich at EM banks, investors should apply some caution, particularly given weaker structures of LT2 in some cases that should warrant an additional discount.
And there might be some selected M&A (merger and acquisition) activity in 2011 driven by in-market consolidation (e.g., Russia), privatization of state-owned banks and foreign banks looking to either increase exposure to EMs or divest assets in order to comply with new regulatory requirements.
C. Oil and Gas:Following a sharp recovery in 2009, oil prices remained high during 2010 relative to historical averages. (Last year's WTI oil spot price averaged $80 per barrel, with a trading range of roughly $68 to $92.) However, given continued increases in service costs and continuing growth in EM demand, we do not expect oil prices to revert to low levels observed in 2009.
For Russia, we expect a fairly stable, perhaps slightly declining oil production from current peak levels. While underlying cash flow generation should remain strong and financial profiles of oil companies should remain at current robust levels, a likely positive catalyst in the future will be a revision of the current oil taxation regime. This should be a positive for the profitability of oil producers as the government has to incentivize producers to invest in new producing areas to secure long-term stable oil production levels and thus tax income in Russia. On the natural gas front, we recommend exposure to select names because of the localized nature of natural gas markets.
In the case of Brazil, and different from the recent past, we've seen growth in oil exploration that we have not seen in the past 15 years, particularly with the Santos Basin discoveries in Brazil. We are now beginning to see some commercial production from the discoveries in the pre-salt region. Although there will continue to be technical and logistical challenges for deep water drilling, once they've identified a reservoir of oil, the project becomes less difficult and volume will certainly come (at least after 2015).
For the 2011 outlook, we continue to recommend overweight in the sector given spread pickup relative to developed world exploration and production (E&P) credits. Our review of 2011 capex plans indicates that we should expect additional debt issuances from Latin America E&Ps.
ConclusionAt PIMCO, we believe several factors have aligned in favor of emerging markets, especially considering headwinds to growth are battering more developed nations. While the U.S. should see a modest boost in economic growth this year from expansionary monetary and fiscal policies, including the extension of Bush-era tax cuts, we see developed nations expanding at a 1% to 3% range this year compared to 4% to 8% for EM (namely China, Brazil, Russia, India and Mexico).
Developed nations continue to face private sector deleveraging, fiscal deficits and more intrusive financial regulation. Leading emerging nations, meanwhile, have generally healthy public and private balance sheets, and are experiencing robust growth. Indeed, in this multi-speed world we continue to expect a migration of global wealth and growth dynamics to emerging economies "“ all good signs for EM corporates. At PIMCO, we hold approximately $55 billion of EM securities across our portfolios as of the end of 2010.
EM corporates have experienced healthy corporate profits, positive cashflows, low cost structures and manageable debt profiles. Another key to the EM corporate story is our focus on industries such as oil and gas, utilities, metal and mining, and banks that we believe will benefit from EM governments that understand the importance of these industries as structural elements of every economy. Also, investments in these industries help EM nations nurture domestic demand needed to continue economic growth
Finally, note that strategically the characteristics of EM corporate bonds may complement traditional asset classes in return generation, while providing the additional potential benefit of portfolio diversification, as seen in the Figure 7 correlation chart.
Put it all together, and the future looks set to include an expanding opportunity set for investors in EM corporates.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.
Barclays Capital U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The Barclays Capital U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury. The J.P. Morgan Emerging Markets Bond Index Global (EMBIG) is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. The J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) is a global, liquid corporate emerging markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging markets entities. The J.P. Morgan US Liquid Index (JULI), provides performance comparisons and valuation metrics across a universe of investment grade corporate bonds, tracking individual issuers, sectors and sub-sectors by their various ratings and maturities, The Investment Grade CDX is an index comprised of 125 credit default swaps on individual investment grade credits. Tranches on this index are structured by order of loss from defaults among the underlying components of the index. The On-the-Run Investment Grade CDX index refers to the most recent series available at a point in time. The Morgan Stanley Capital International Emerging Markets Index is an unmanaged index that measures equity market performance in the global emerging markets. As of May 2005, the Emerging Markets Index (float-adjusted market capitalization index) consisted of indices in 26 emerging countries: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey, and Venezuela. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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