The emerging market recession appears to be bottoming out on a cyclical basis, according to M&G’s Claudia Calich, although she believes Mexico could be one of the few countries to experience a growth slowdown following the election of Trump as US president.
Given this backdrop, Calich – who heads up the five crown-rated M&G Emerging Markets Bond fund – has increased the portfolio’s duration as well as its exposure to local currency-denominated government debt at the expense of hard currency-denominated credit.
While she believes the fall in commodity prices experienced in 2014 and 2015 has flushed some of the weakest credit issuers out of the system which will stand the asset class in good stead, she believes the market area looks expensive relative to sovereign debt.
“The fund actually performed very well in 2014 and 2015 as it had less local currency exposure. Since then, I’ve been increasing the local currency exposure with the view that the valuations have finally improved and, at the same time, valuations on external data are becoming a little bit more expensive versus where they were a year ago,” the manager said.
“We’ve had a large tightening of emerging market spreads, so the hard currency there is not as cheap as it was before and local currency in our view is looking more attractive, so I’ve increasing my exposure from 10 to 15 per cent to almost 30 per cent.”
Calich’s asset class positioning has stood the £389m fund in good stead as it has achieved top-quartile annualised returns during 2013, 2014, 2015 and 2016. Overall, it has returned 47.09 per cent this time frame, compared to its average peer’s return of 11.61 per cent.
Performance of fund vs sector over 3yrs to year-end 2016
Source: FE Analytics
Calich says performance benefited from avoiding defaults in countries such as Mozambique as well as maintaining exposure to key outperforming regions.
Given where we are now in the economic cycle though, she warns that it is particularly important to avoid becoming caught in sovereign restructures or corporate defaults.
“The good news is we’re expecting those defaults, particularly in the corporate space, to start slowing down this year,” she said.
“The main reason is a lot of the defaults that happened last year were related to very sharp falls in commodity prices, particularly in some of the weak oil names or mining firms. There were also problems with some sector-specific companies such as construction companies in Brazil or other issuers that were caught up in this whole political corruption scandal.
“The weaker credits then default and what you’re left with is stronger credits. In other words, if they manage not to default during this tough time, then they will most likely be companies and countries that will survive without defaulting.”
As such, Calich says corporate bonds have become expensive relative to local currency-denominated government bonds and has therefore reduced her exposure to the asset class.
If neutrally positioned, M&G Emerging Markets Bond would have one-third in corporate debt, hard currency-denominated government debt and local currency-denominated government debt respectively. However, it currently has just over 20 per cent in credit at the moment.
Not only is this due to toppy credit valuations, it is also a play on the attractive valuations of local currency debt.
“One of the themes that can be seen within our local currency exposure is a preference for those that have higher yields, so our largest currency exposure is in the Brazilian real and the Russian rouble,” the manager explained.
“Mexico peso has been interesting. I went into the US election fully-hedged, so I had taken the peso exposure off and was essentially buying dollars on a forward basis – I did keep the peso bonds but just not with the currency exposure.
“The day after the results, when we found that Trump had won, the peso depreciated by about 10 per cent. So, at this point, it seemed to be time to price in really bad news in terms of immigration, remittances and all of the noise that is going to start impacting Mexico. That’s one of our top five currencies.”
Calich also increased the fund’s overall duration last year and, since the US election, has been increasing this further so it now stands at an average of more than five years.
She says the reason for this is partly because of the Treasury sell-off in the immediate aftermath of the US election, which was caused by expectations that Trump’s proposals for fiscal policy would lead to reflation and increase growth momentum.
“In my view, markets were already pricing in too much growth,” the manager said. “The tax cuts will be interesting to see in light of what happened with the Obamacare bill being rejected in Congress. That’s on the US side of things.
“In terms of EM duration, you had a couple of countries – particularly right after the US results – that sold off, but these included countries that normally don’t have much of an economic tie with the US.
“Some of the Romanian bonds in dollars, for example, experienced a huge sell-off, not only because US Treasuries were selling off but also the Romanian risk premiums and spreads were becoming higher.”
As a result, Calich increased the portfolio’s overall duration through a number of emerging European bonds.
While she is positive on the outlook for most emerging market countries, however, she believes Mexico is one of the few developing economies that will experience a growth slowdown as the year progresses.
“We still don’t know if Trump will be able to change NAFTA (North American Free Trade Agreement),” the manager pointed out.
“The problem is that, until these uncertainties are resolved, many investors will put everything on hold because you don’t know what the future will look like.
“Also, because you had such a big currency depreciation last year, this is now finally starting to filter through to consumer prices. Inflation is starting to tick up which is why the central banks has been hiking rates for a while, which means you will most likely see retail sales start falling.
“The best situation here would be for Mexico and the US to start negotiating as soon as possible and, eventually, if it is a case of changing part of NAFTA, get it done, ensure it’s fair for both countries and at least we will be able to put this uncertainty behind us.”
Since Calich took to the helm of M&G Emerging Market bond in 2013, it has returned 50.7 per cent compared to its sector average’s return of 22.76 per cent.
Performance of fund vs sector under Calich
Source: FE Analytics
It has done so with a top-quartile maximum drawdown (which measures the most money lost if bought and sold at the worst possible times) of 6.07 per cent and a top-quartile annualised volatility of 9.81 per cent.
It has a clean ongoing charges figure (OCF) of 0.77 per cent and yields 5.45 per cent.