PIMCO - EMW - Mewbourne

Click here for Curtis Mewbourne's biography.

Emerging Market external and local debt indices posted strong gains of 9.9% and 15.2% respectively for 2006.¹ The structural improvements that have transformed the asset class during the last few years continued to pay dividends, as external spreads and local interest rates continued their declining path. At the same time, 2006 provided several reminders that, notwithstanding the significant structural improvements of the past years, there are still important risks to watch in emerging markets. Let’s take a brief look back at the developments of 2006 and then forward to what 2007 may bring.

The first reminder of EM risk in 2006 was of contagion, when fears in May and June of increasing G-3 rates led to a broad-based sell-off of EM external and local instruments. In fact, the volatility wasn’t limited just to EM debt, but impacted both equity and debt instruments across most developed and developing countries. Given PIMCO’s views on the solid position of economic and financial fundamentals for the EM asset class as a whole,² we viewed the external disruptions as temporary and unlikely to negatively impact the asset class.³

Within our constructive secular view of the EM asset class, we try to view days when all assets trade down in response to an external event as if our local grocery store hung out a sign reading “10% off all items!” On such days, you don’t need to buy everything, but it’s certainly a good time to stock up on things that you want to have in the coming weeks and months. And while we won’t go as far as to predict another bout of price contagion in May/June 2007, it is interesting that we witnessed similar episodes in May/June of 2005 (Ford/GM downgrades), 2004 (Fed rate hikes), 2003 (U.S. rate moves), and 2002 (election concerns in Brazil) – all of which proved to be good investment opportunities.

The next reminder in 2006 was of political risk, with a military coup in Thailand in September and the rise of a leftist candidate for president in Ecuador in October. Investors initially shrugged these off, perhaps since the vast majority of the heavy 2006 political calendar had resulted in market friendly outcomes.

Unfortunately, in December these political risks morphed into financial risks. In Thailand, the military government implemented capital controls, only to partially reverse them after local equity markets dropped 15%. While in Ecuador president-elect Correa and his designated finance minister reiterated their intentions to “restructure” Ecuador’s government debt.⁴

The case of Ecuador is interesting, because Ecuadorian bonds had generated strong returns in 2004-2005 ⁵– a period during which oil revenues gave Ecuador’s government ample capacity to service its debt.⁶ This spring, however, we became concerned about the willingness (as opposed to ability) to repay debt when in March the government effectively “nationalized” oil production facilities controlled by Occidental Petroleum. A visit to the country gave us additional concerns about the quality of the various presidential candidates and their platforms. At the same time, the market seemed complacent about the risks, with most Ecuadorian bonds callable at 100, and trading above that price! Given the increasing risks and limited upside, we aggressively sold all Ecuador exposure⁷ prior to the first round of the elections.⁸

In retrospect, these were prudent investment decisions, not because we “predicted” the unpredictable (coups, election results, etc.), but because we believe that proper investment decisions always involve weighing the potential risks and returns within a risk management philosophy that stresses capital preservation.

Outlook For 2007

So with those reminders that financial contagion, politics, and willingness to pay are still very real risks that investors face, let’s take a look at what we think will be the dominant factors in 2007.

Let’s start with the 30,000-foot view, hopefully above the pockets of turbulence. Odds are that the favourable global economic and financial conditions that we have witnessed for the past several years will remain in place. Estimates for global growth in 2007 are in the 5% range, reflecting a continuation of the recent strong trend (Chart 1). Note that this high level of global growth is being maintained despite slower growth in the large developed economies. In recent years the correlation between economic activity in the large developed economies and total global growth has fallen as EM countries have become more important engines of the global economy⁹ (Chart 2). Lower correlations have helped reduce the volatility of global economic growth – a supportive backdrop for emerging markets.¹⁰

Now let’s drop down to the 10,000-foot view to see how supportive macro factors have translated into risk/return in EM assets. A review of historical returns and volatilities for external debt shows an improving trend in risk-adjusted returns. The improvements in EM country fundamentals and supportive global economic conditions dramatically reduced risk while returns have remained robust (Chart 3). For 2007 we expect those same factors to remain supportive.

Some of the best potential returns can be found in EM local markets, where interest rates remain substantially higher than in their developed country counterparts (see Chart 4). We view EM local markets as the next major transition story in the asset class. Strong macro-economic fundamentals and deep-seated institutional changes in the conduct of fiscal and monetary policy have set the stage for a secular convergence of EM local interest rates toward developed country levels.

Finally let’s fly down to low altitude to take a look at how the factors we saw in 2006 might impact the individual regions and countries in EM. As for contagion, we fully expect bouts of volatility to occur in financial markets (maybe even in May!), but we think these will more likely be transient than permanent. On the political front, we will be paying close attention to developments in those countries that just completed presidential elections (Brazil, Colombia, Mexico and Peru, to mention a few) where the focus will shift to policy implementation. On the financial side, risks will of course remain for those countries with large current account deficits like Hungary, Turkey and South Africa, given their dependence on external capital.

While 2007 will undoubtedly contain surprises, as always our primary objective will remain to manage our clients' investments in a prudent and optimal manner, and we look forward to meeting that challenge in 2007.

Curtis Mewbourne

Executive Vice President

¹ As represented by JPM EMBIG and GBI-EMGD indices
² See the discussions in March 2006 EM Watch “It’s the Economy, Stupid…” and September 2006 EM Watch “Is it Safe?”
³ See the June 2006 EM Watch “The End of the Asset Class…Hardly”
⁴ Restructure likely means lowering the coupon payments and extending the maturities of bonds, both of which reduce the value of the investment
⁵ JPMorgan EMBIG Ecuador Subindex returned over 17% per year from 12/31/03 - 12/31/05
⁶ Oil revenues in 2005 for Ecuador were $2.2bn and $1.6bn for first half of 2006 according to Morgan Stanley
⁷ Over 25% of Ecuador’s outstanding government debt
⁸ Bonds have since fallen some 25 points on concerns of a debt restructuring
⁹ Correlation shown in chart is for rolling 10yr periods
¹⁰ Volatility shown in chart is for 5yr rolling periods