For emerging market investors who always have their eye on the worst-case scenario, the ripple effects of the Covid-19 market crash have left many fund managers faced with this reality.
Tina Vandersteel, head of emerging market debt at GMO, said Citywire Selector that the depth of the recession had taken many investors by surprise and that only a group of better-quality countries had resisted.
“We are in a shock that I think anyone would call a worst-case scenario for the global economy. Such a shutdown of economic activity on a global scale is unprecedented in our lifetime.
“Our focus on instrument selection, among other things, results in assets in the portfolio that show some default protection relative to our benchmark.
“For example, in countries with low credit quality, we direct holdings to cheaper assets that often present fewer downsides in a crisis. For example, this strategy helped to limit our losses in Ecuador, which went from a parity-priced country at the start of the year to an asset priced below 20 at the height of the crisis.
Vandersteel has previously explained how it constantly works on a “worst-case scenario”, which would mean it limits exposure to countries that are likely to default. However, the Boston-based fund manager said there will be an increase in defaults over the next few years.
“Our sovereign analysts are spending more time on our models that estimate likely recoveries in the event of default, because we know we will have a peak in sovereign defaults this year, and possibly into 2021,” she said. declared.
“Sovereign defaults are rare, but this year will see a spike, from countries that were already in distress before covid-19, such as Lebanon and Argentina, and those that were pushed into distress by covid-19 and the oil shock, like Ecuador.Countries that were over-indebted before Covid-19 will likely use the current crisis to make the case for longer-term debt relief.
Moving up the quality spectrum
Vandersteel sought to respond to the challenges caused by the crisis by adding quality securities, which led it to reduce its underweight in low-yielding and investment-grade sovereign securities. She selectively added Malaysia, Israel and Qatar.
In addition, with the opportunities presented by China recovering faster than other markets, his team also looked into the Chinese market, especially state-owned enterprises. “The fact that the sector has outperformed the market has made it less attractive in terms of relative value. There are many details in the documentation that need to be considered, such as legal jurisdictions and bondholder rights.
“So for us, it’s not as simple as blindly buying Chinese state-owned companies and assuming they pose Chinese sovereign credit risk. We also note that China itself is trying to encourage a credit culture in the domestic market by allowing some state-owned enterprises to default on their own.
Elsewhere, Latin America continues to present its own challenges – as our own EM Insider expressed in its latest podcast – with the potential impeachment of Brazilian President Jair Bolsonaro having to be weighed accordingly.
‘Currently, [our sovereign analysts] thinks that the decline in his popularity rating is not enough to encourage politicians to engage in a long and entertaining process when politically the priorities are on the health situation.
“Instead, they are focusing on Bolsonaro’s relationship with Minister Guedes and Congress, as Brazil is in a precarious fiscal situation.” More generally, the Covid-19 crisis is on the one hand bringing people together against a common enemy, but it is also revealing underlying fissures in global politics and national politics, due to the extreme measures taken to combat the virus. .
Vandersteel said his team is positioning itself for the Bolsonaro regime to survive the impeachment process, but other concerns persist. Most notable being a potential blemish from a bigger EM player.
“The broader concern for the asset class is a financial and social crisis leading to a default in a large, more systemic emerging country, such as Brazil, Mexico, Turkey, Russia or South Africa. At the moment, we only see defaults in the most predictable countries, such as Argentina, Lebanon and Ecuador.
Vandersteel runs a $3.9 billion version of the Emerging Country Debt fund for US investors, as well as overseeing a Ucits-compliant version that launched earlier this year. In the US fund, its main exposures are to Turkey, Mexico and Chile, while running a significant overweight in Argentina, as at the end of March.
In terms of performance, Vandersteel lost 2.1% in US dollars over the three years to the end of March 2020, which compares to a loss of 4.9% for the average bond manager – Global Emerging Market Bonds Hard Currency over the same period.