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China, Brazil Cause Headaches for Emerging Market Investors

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In a webinar on Tuesday, DoubleLine Funds offered its outlook on emerging markets and provided an in-depth look at risks in China and Brazil specifically.

DoubleLine identified several country-specific risks for investors in emerging markets: what it called the “terrible three” of Argentina, Venezuela and Ukraine; countries in transition like Brazil and Russia; and, of course, Greece. (MSCI downgraded Greece from developed to emerging market status in late 2013.)

Rising Treasury yields, the global slowdown in growth and falling commodity prices are also risk factors, according to Luz Padilla, director of emerging markets fixed income for DoubleLine.

Padilla said it looks like the Federal Reserve will not increase rates this year, but if it does, the increase will happen slowly enough that it won’t have a significant impact on emerging market debt. 

Both developed and emerging markets’ growth have shown a “ratcheting down,” Padilla said. The International Monetary Fund recently released its growth expectations for 2016, predicting emerging markets will grow 4.5%, down from 4.7%. Globally, growth is expected to be down to 3.6%, and in developed markets it’s 2.2%.

DoubleLine is also watching elections in Argentina, Venezuela and Turkey in 2015, and in the Dominican Republic, Peru, the Philippines and the U.S. in 2016, Padilla said.

Venezuela continues to have issues with oil pricing, Padilla said, and Nigeria has struggled with energy prices as well.

“No doubt we have seen a deterioration in the growth market for emerging market debt, but a lot of these economies are coming from a pretty robust base, so I think they can manage the slowdown,” she said.

DoubleLine funds were down 2.5% to 2.8% in September, Padilla said. “Part of that differential has been attributable to the Ukraine restructuring, but also, Russia has had a very sharp rebound and we have been out of Russian bonds this year,” she noted.

“We’re mostly watching the situation in China and growth expectations, and specifically how those correlate to commodity prices,” Padilla said. “We’re also monitoring the situation in Brazil very carefully because that has had implication in terms of sentiment for the rest of the region.”

Bill Campbell, an analyst for DoubleLine, said that the situation in China has caused “major indigestion in world markets, especially in this past quarter.”

The equity rally that began last year was promoted by the government, he said, and was expected to offset the weakness in the housing market.

“This crescendoed on June 10,” he said, when it was expected that MSCI was going to include China A-shares in its emerging market indexes. That didn’t happen, which “was pretty much the marker of when this equity market rally had gotten ahead of itself” and started to unwind.

As investors began to unwind equities, the government pushed a stability fund, required purchases from state-owned companies of their own equities, then sold securities held less than six months, “all in an attempt to stabilize the market,” which they did, according to Campbell.

“Unfortunately, these interventions caused a distortion in the market,” he added. “People had been looking at the equity market as an indication of underlying strength or weakness of the Chinese economy, but now the government intervention stabilizing the equity market has clouded that as an indicator for market participants.”

In August, the People’s Bank of China devalued their currency 2%, Campbell said. “That seems like a very small amount, but we can see is that basically erased the gains that their currency had seen over the past two years.”

He added that “there is no doubt that China’s growth has been slowing since their stimulus following the global financial crisis.” The country is changing its growth model from an export and investment-led model to a more services- and consumption-based model of a developed economy and are still in that transition, he said. Slower growth is typical during those types of transitions, according to Campbell.

China has a “very strong balance sheet,” Campbell said, with reserves of $3.6 trillion, net foreign assets of $4.4 trillion and a trade surplus of an average $45 billion a month. “They have a lot of reserves in order to help implement policy levers that can support growth,” he said.

Policy changes that have already been enacted include cutting interest rates (to 4.6%, which gives them room to cut more if necessary); easing reserve requirements for banks (to 18%, which again gives China “plenty of room and a lot more firepower” to add more liquidity); easing home purchase regulations, which has already resulted in stabilization of home prices and in some areas, increases; and easing local government debt financing.

Campbell said these measures are helping stabilize the growth picture, if at lower rates than in the past.

The growth transition will be bumpy, he said, and “communication is key. We think that if there would have been more early warning and effective communication around the change in FX policy, there’s a possibility that the market might have actually digested that change in FX policy the way China wanted.”

Going forward, he recommended investors watch “very carefully” how China communicates with the market.

Campbell added that the European Central Bank and the Bank of Japan have indicated they’re considering increasing their quantitative easing policies. The ECB is purchasing €60 billion in government bonds per month, with some talk that ECB President Mario Draghi may extend the deadline for the end of the program beyond its December 2016 date or increase the amount of purchases if inflation continues to disappoint. The BoJ is purchasing 80 trillion yen per year, he said, with discussion that as growth and inflation slow, it could increase QE as early as the end of October.

The strength of the dollar is a headwind for commodities, Campbell said. “Commodity prices show an inverse correlation to the dollar as they’re priced in dollars,” he said. “As the dollar appreciates, that weighs on commodity prices going forward.”

Valerie Ho, another DoubleLine analyst, provided a closer look at Brazil. In addition to the same problems that other emerging markets are enduring, the country is also facing significant political headwinds in President Dilma Rousseff’s unpopular fiscal and structural reforms and corruption charges regarding the state oil company, Petrobras.

Political uncertainty has led to lower investment in Petrobras and construction-related companies, Ho said. Falling business confidence and lower investment has led to lower growth, she said, but it’s also had an effect on the labor market and unemployment has risen while wages have fallen.

“This has led to a contraction in private consumption,” she said.

Second-quarter year-over-year GDP in Brazil fell 2.6%, and Ho said DoubleLine expects more negative growth for the rest of 2015 until it bottoms out toward year-end 2016 and growth kicks up some time in 2017.

Debt as a percentage of GDP has risen to 65% from 54% in 2013 and is expected to reach 70% over next year, Ho said. The target is 0.15% for this year, but even if they meet that, Ho said, “we’ll continue to see a rising debt level, as it takes 2% to 3% primary fiscal surplus to actually stabilize the current debt levels.”

The Brazilian real has deteriorated more than 30% this year compared to the dollar, she said, adding that until the country resolves its political issues, volatility will continue.

There are growth opportunities for the future, though. As imports become more expensive, more domestic production should increase, Ho said.

The long-term outlook as better as well. The country has robust international reserves, and is a net external creditor. About 85% of the deficit is funded by “very sticky” FDI, Ho said.

Local markets are deep and liquid, which will support the corporate sector going forward, and the central bank has been working toward “building credibility with a very targeted inflation mandate,” Ho said.

“We think these risks are well understood by markets, but the question we’ve been getting a lot is, ‘Is this priced into the current bonds?’” Ho said. She said Brazil is spread “much wider than its investment-grade peers” and is trading more in line with B- and BB-rated peers. “While we see political uncertainty going forward, which will create a little more volatility, we think ultimately the below investment-grade rating the S&P has assigned for Brazil is largely priced into the market.”

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