EM Fixed Income: To every thing there is a season

Hello, and welcome to our At Any Rate Emerging Markets Focus podcast, a place for us to discuss recent developments and key issues of focus in the emerging market fixed income asset class. I'm Jonny Goulden, Head of EM Fixed Income Strategy here at J.P.Morgan, and I'm joined by Aneshka Krishnarova, Head of EMEA EM and LATAM Local Market Strategy, and Ben Ramsey, Head of EM Sovereign Credit Strategy, both at J.P.Morgan. Aneshka, Ben, thanks for joining again.

Hi, Jonny. Nice to be here. Hi, Jonny.

Hi, Aneshka. So, the closure of the Strait of Hormuz, the blockade, and the next steps in the Iran conflict, given their stagflationary impacts, which we are starting to see a bit more now in the data, they're obviously still the most important and powerful drivers for EM and global markets here. So, in today's discussion, which will be the last one that I will be doing at J.P.Morgan, we will start with the latest views from the team about emerging markets.

We've just updated in our monthly publication, Emerging Market Outlook and Strategy, and so we'll talk about the overall view, and then we'll focus a little bit on some of the key idiosyncratics, particularly the impact of elections and some political developments, which are impacting EM country outlooks in Latin America and also in the CE region, which we have been following. So, Aneshka, let's start with the overall markets view. It feels like we're in a different phase of this conflict now, where we still have the downside risk for the global economy, given Strait of Hormuz remains shut, there's a blockade, but this is now being done without the fighting.

Obviously, we are in a ceasefire period, and also, we have had an enormous rally back in risky assets, which makes this different from the earlier phases of this conflict. So, how are you looking at the EM local markets environment here? Does this require any changes in stance as far as you're concerned?

Indeed, I think your question frames it really well. We are in a different phase. So, in the first phase, we were dealing with very volatile market moves, very dramatic events on the ground.

At some moment, we even almost hit extreme negative risk appetite levels on our favorite index. Now, when we compare it to now, valuations in EM have become a bit more extended, especially in effects. We have several currencies that are comfortably trading stronger than before the war even started.

We retraced back in a lot of the pro-cyclical assets, not as much as in rates, but certainly across the more pro-cyclical part and higher carry part of the spectrum. So, the valuations have been eroded. Second, it is again a judgment call, but our EM FX risk appetite index told us that positioning has been built back in, especially in FX.

The degree is a little bit of a debate, but certainly I think the judgment that positioning did increase is correct. And now, against that, we are dealing with a substantial uncertainty on the ground. While the conflict was ongoing, we were getting guidelines from the relevant military authorities regarding number of targets, the expected duration of the conflict.

Now we are in a period where the guidance is quite limited. There is a lot of uncertainty about the progress of the underlying negotiations. Latest headlines suggest that a blockade may have to be in place for weeks before it generates sufficient negotiation leverage.

There is also the cross-reliance on market price action, as markets are not generating pressure on the relevant policy actors. We are getting guidance of extended deadlines and vice versa. And finally, there is the obvious issue that the longer the situation in the strait extends, the more pressure there will be on all markets that start to run out of inventories.

It is a very, again, difficult topic to what extent, how far are we along that storage or inventory drawdown issue, but certainly it appears that it is indisputable that the longer the conflict persists, the harder the outlook for all prices. So where we stand here, valuations worse, positioning higher, uncertainty higher. I do think that it does warrant more caution.

That is the direction that we have taken in our monthly publication. So we have become less constructive on the asset class. I would, at the same time, as I say that, less constructive, I would say neutral stance is the most appropriate.

It gives the most optionality. Given that we are picking parts of the spectrum that we think can be more resilient, I would say at the same time turning outright bearish is also a very difficult position and one that we have avoided taking. It seems that one that underlying fundamentals as well as the dynamic on the ground does not seem to support.

Great. Thanks. So a little bit more cautious given the extent of the rally back versus the ongoing and maybe increasing uncertainty now.

I guess the second part we should discuss is that in the middle of this period where central banks are making their decisions, we probably would not envy them that at the moment given the balance between inflation and growth risk and that large uncertainty. So who knows what the next month is going to bring. We had the Fed last night.

We have got the ECB. We have just had as well. Does the less positive view on EM rates versus EMFX still apply as you have been talking about in previous podcasts given central bank views and to what extent do you think that needs the Fed, let's say, to stay a bit more passive rather than in previous conflicts or situations where they maybe have transmitted this by the FX channel?

The view is that rates are more vulnerable than FX given our base case has been that this is more a reflationary shock, one that increases inflation but does not necessarily hurt growth as much. In that environment, rates underperform FX as well as high yielders outperform low yielders. Now the obvious risk is that if we turn into a inflationary environment that the rates reaction becomes very different across the space.

There would be probably some low yielders with safer fundamentals that can afford to perhaps not hike and in very rare cases perhaps some might even be able to respond to growth risks where the high yielders on the other hand, that rate space would start to suffer. I would say that that's that inflationary risk is on the margin increasing but I would still think that the scenarios where these types of dynamics hit are still relatively further away given the starting point of resilient growth. So where we started from, we still have buffers before this complete opposite ranking between rates and FX starts to kick in.

Now in terms of the Fed, I couldn't emphasize enough how much I think that the Fed contained reaction to the oil prices or in general to the environment have been important for risk assets for our asset class. When we look at the point at which pro cyclical assets started to outperform, whether it's equities, EMFX or the higher yielding rates, that is exactly the end of March where we see a divergence develop between US real yields which started to come lower and US break even rates that started to go higher from that point. That is another way of saying that with Fed having a certain asymmetric reaction function, the Fed is not making the shock any worse for us and it is allowing other central banks to respond in a slower fashion, not a fashion that would exacerbate the growth risks.

I think that's a crucial assumption. My own interpretation from the meeting yesterday is that assumption is still valid and I think that's also the view from our economics team which thinks that that underlying assumption is valid even in the more aggressive oil price scenarios. Great.

Thanks, Ineska. So, Ben, let's turn over to the EM credit markets and really coming back to the first kind of overall standpoint of how you see EM sovereign credit markets in the current new phase context we've been talking about. Do you think we're back to a period which we felt I guess early in the conflict where we're being under compensated in risk premium for the risks?

Should investors be looking at hedges at these levels? How are you seeing it? Yeah, Jonny.

I mean, I think broadly we're still kind of in the same place. Levels are still hanging around at 13-year tights and 13 years ago when they hit the levels where we are now, which is around 240, 245, it was very brief and we've actually been hanging around at this level for quite some time now in the post-ceasefire rally and that's where we were back in February before this all started. So it's hard to say here that there isn't sort of asymmetric risk here in terms of where spreads could go.

I think we're still conditioned here by seeing anytime we get any bit of value put into spreads, the market kind of jumps on it and still conditioned to this idea that at the end of the day there's going to be a resolution here that does not produce a worst-case outcome, which effectively would be bringing these circulation risks to the table, some type of increased global recession risk to the table. So I don't think we're at all priced for that outcome. We have seen in the last week returns have started to bleed a little bit lower, but it's not because spreads have moved higher, it's really just the fact that treasuries have pushed up.

We have seen some of the best performing sort of higher yielding credits take a little bit of profits, so we've seen that a bit in Venezuela. Argentina is always a little bit its own animal, but it's also been an underperformer over the last week. So I think that there's a bit of signs of some caution here.

We ourselves think a bit more caution is warranted. We had been much more cautious on the NB Global Diversified Index overall about a month, about six weeks ago. We got a little bit more neutral in line with what Agnieszka was talking about, but we do think it's perhaps worthwhile looking to hedge spreads at these levels, and there are derivative products.

CDXEM is something we've mentioned that could be a useful tool to basically start to hedge these risks. Great. So that's the overall environment.

Now we're going to really delve a little bit more into some of the idiosyncratic drives in EM at the moment, and they are mostly focused around elections with a bit of politics not election-related. Those in Latin America are probably most prominent right now. Ben, let's start with you, given your Latin American knowledge and background.

Could you maybe just bring us up to speed with the election cycles in the region, specifically the latest developments and focus in Colombia and Peru? Sure, Johnny. Yeah, I mean, your last podcasting, you were handing me a Latin elections question, so if anyone gets in trouble, it's me.

But sure, let me talk about the market of watching both of these very closely. I would say Colombia a bit more than Peru, but let's start with Peru, because that's the one we're really in the middle of. We're several weeks since having the first round.

We're about a week away from the June 7th second round runoff, and we only know one of the participants in that runoff, so a lot of uncertainty. Peru is certainly used to uncertainty in terms of at the presidential level. There's been a lot of rotation of different presidents within the term and throughout the last decade, so I don't think the market is sort of hyperventilating over the outcome here, but there is a bit more concern just as far as we had a field of mostly center-right candidates who would have been proposing mostly similar macro policies and pro-business policies, and one of the few candidates on the center-left, or let's say more towards even far left, it looks like is the best position to get into this second round vote, which again is only a week away.

So that makes this outcome a little bit more binary. The initial polls show between that candidate, who is Castillo, and the right-wing candidate who we know, which is Fujimori, show basically a tie in terms of second-round intentions, which again makes markets a little bit nervous in terms of what the outcome may be. We've noted that Keiko Fujimori has been a candidate in the second round in the last several elections.

She's never made it past the second round. She's actually pulling better this time around than in the past, so I think this is still a very competitive election. There are a bit more institutional constraints in Peru than in the past, now that there's been a reform that effectively broadens the role even more of the Congress putting in a Senate, which hadn't been there before.

So checks and balances are going to be strong one way or the other. So I think we just have to wait and see here, but certainly we've been cautious, and I guess this team's been cautious, particularly on the FX side in Peru. On the credit side, we've just been more neutral.

Colombia is one which is potentially more consequential, and it's maybe odd to say that because we do have a left-of-center incumbent, so were they to be re-elected, at least the candidate of the current government's party be elected, maybe we can just think of more of the same, but I think more of the same could be quite complicated for Peru's economy. The fiscal deficit has widened quite dramatically. Debt dynamics look challenging, and now lately there's been challenges to the independence of the central bank.

As we get into a second term with a left-of-center government, they could start to really populate the institutions, including the central bank, which has served as checks and balances there, have served as anchors to basically the macroeconomic policy, and I think we could sort of feel like Colombia's economy could be a bit more adrift. Not that the challenges would be small if we do get a right-wing or a center-right president, which again in Colombia we're not even yet at the first round, that will be at the end of this month, at the end of May, and then we'll go into June for the second round, so there's plenty of campaigning yet to take place here. A center-right president would face important challenges, the most important one probably being fiscal correction, which won't be easy for anyone, but probably market participants in the local business community would be much more patient and forgiving in terms of continuing to finance deficits as long as there's a path towards consolidation.

Got it, thanks for that. So Aneshka, given that election process, processes that Ben has outlined, how are we thinking about that translating into local markets opportunities in those LATAM countries, and maybe we should also bring in and compare, contrast with Central Eastern Europe where we had a Hungarian election outcome which markets saw favorably, but now we're seeing some political noise in Romania, how do you contrast those? Let me first deal with the three that are election-directed, election-related.

In Hungary obviously the election has happened already, in Colombia and Peru we are still to see the final result. So obviously these are all idiosyncratic cases, but from a local markets perspective, what they have in common is the following. They provide a relatively stark differences in macroeconomic proposals.

So that's the first thing that they have in common, and the second thing they have in common is that it's not easy ex ante to claim that the probability is heavily skewed to one side or the other. We are not dealing with an 80-20 case, in all cases in Hungary it was at the start something closer to 50-50, in the other two you might argue it's up to 60-40, but it's certainly not an 80-20 clear case. So that's what is common, an opposing macro policy with not clear, with close probability outcomes.

Now, what is very different is the starting point of valuations. I would very much emphasize that. And what is also different is how these different currencies or local markets fit into the global themes.

How are they positioned in terms of carry, in terms of trade, etc. So if I take them in turn, the easiest one has been Hungary, where it's already happened and we've been constructive and we remain constructive, but the key point is that we had it into the elections fundamentally cheap on any comparison to the region, and the cheapness has made that call easier. Now when we look at Peru or Colombia, we would say that the risk premia are not substantial.

In Peru they have started to build, but they are not substantial. In Peru, our concerns are along the lines of carry, inflationary pressures in terms of trade, so when we take it as a package, it makes us more cautious on effects and local rates. So it's a package that then leads to a recommendation.

In Colombia, the terms of trade is supportive here, but the valuations are rather expensive and there are various flows that make the price discovery of what is actually price difficult. So in Colombia, we are rather neutral. Great.

Thank you. Ben, let's quickly maybe finish on those situations on the sovereign credit side. We tend to have less in our views, I guess, in those opportunities just because they're generally quite low spread and there's usually other stuff to be focusing on.

Is there anything you think, election politically related in those opportunities in sovereign credit, or do you think, as we've talked about previously, the focus is still on more of the higher yielding parts of the market? Yeah, no, I think it's definitely here on the higher yielding parts of the market. I think if we think about Hungary, there has been some concerns on the fiscal side, concerns on how that may translate into more supply, but we basically see this offset by optimism around the change in government, the EU support.

I think if there's some sense that that can stagnate, maybe there's a bit more, Hungary's price is now a very good outcome and maybe there's some upside risk to spreads there on the margin, but I think it's not something we're sitting at thinking is a big home run opportunity. I think the moves where, the ones where we can have big moves on the back of the elections, Peru is uncertain, but less so than a Colombia, the one I mentioned before. I just think that the outcome there feels a bit more binary spreads, I think are more positions there for a return of fiscal normalcy, even if gradual.

Certainly not positions, spreads are not set up for something which would be consistent with a deterioration of debt dynamics and I think that that's on the table, depending on the outcome, more rating downgrades are on the table, depending on the outcome. There we've looked at opportunities in basis, bond CDS basis, basically where the bonds look a little bit richer than the CDS. Some of that is technicals based on very impressive amount of bond buybacks, which the current public credit offices has carried out and the CDS I think is reflecting a little bit more the binary risk of the election outcome.

So if you want to take a directionless view here, we think there's opportunities potentially in looking at that difference between bonds and CDS. Great, well thank you and this brings us to the end of this J.P. Morgan At Any Rate Emerging Markets Focus podcast.

And after four years so far of the podcast, this is the last I'll be participating in as part of my time here at J.P. Morgan and I will leave it in the very capable hands of Aneshka, Ben and the rest of the team here. A big thank you to all of those who have been regular, irregular listeners over the last few years and hope you'll be back with the strategy team for the next one.