EM bonds back in savers’ good books

Improving credit fundamentals, relatively low sovereign external debt levels of 43 per cent of GDP – far lower than developed counterparts – and a light political calendar in emerging market countries this year means there is good reason to be mildly bullish.

However, there are two key factors that will shape the direction of not only the emerging markets debt asset class but that of the global financial system as a whole. The first is the presidency of Donald Trump, which is likely to reform the structure of the US as a global economic and geopolitical leader.

Any risk of escalation between China and the US will have a significant impact on all emerging markets. If a deterioration in the relationship leads to a trade war it would be disastrous. However, even accidental attacks via Twitter, as we have already seen, can create tension in markets.

 The global political leadership changes that are taking place in the western world will significantly impact emerging markets

It is important to realise that China is completely different to the country we have seen in the past. Twenty years ago, the country’s foreign policy was very reserved; this attitude is changing and we now have a different style of leadership, one that wants more power in Asia and to be regarded as a true global player.

There is, of course, a big question mark over China’s debt. The country is in an almost unique situation: While corporates in most emerging market countries have de-leveraged their balance sheets over recent years, China’s have overseen a huge increase in debt levels. The country’s total debt to GDP has also soared to an astonishing 280 per cent of GDP, and it is concerning that most of it relates to non-financial corporate – not sovereign – debt.

This is a worrying trend and not sustainable over the longer term. While we don’t believe a systemic risk in China will emerge this year, it will be key to watch out for into 2018-20, when there will be greater clarity about the Sino-US relationship.

Undoubtedly, there is a need to clean up China’s debt situation and we may start to see more defaults both this year and in the coming years, as the Chinese government selectively bails out indebted companies.

Another decisive factor for emerging markets debt in the year ahead will be the direction of US Treasury yields and the US dollar. Ultra-low yields in the western world, attractive Sharpe ratios and fair compensation for political and liquidity risks are all factors that favour emerging markets debt.

However, as we saw during the ‘Trump Tantrum’ in November 2016, emerging markets bonds are hugely receptive to any volatility in core rates. Should there be a geopolitical accident, or a rise in US Treasury yields and the dollar, this might lead to heavy volatility for emerging markets bonds.

Interestingly, the election of Mr Trump suggests there may be a more open dialogue between Russia and the US, especially on issues such as Syria and Ukraine, although it is unlikely that all sanctions against Russian entities will be lifted.

From an investment point of view, Russian hard currency sovereign and corporate bonds do remain attractive. Strong fundamentals, a low degree of leverage and favourable technicals with relatively low supply expected makes them one of the brightest spots in the emerging markets debt landscape for 2017.

All this suggests geopolitics is back on stage – but this time the key risks are those arising in developed markets.

The global political leadership changes that are taking place in the western world will significantly impact emerging markets. Furthermore, there are questions following Mr Trump’s win and potential new US policy orientation over who will be capable of taking on the global leadership role now.

According to the US political scientist Ian Bremmer, we are entering a ‘G-Zero’ environment, which means there is an emerging power vacuum in international politics, coupled with a decline of US and European influence, resulting in the world having no true global leader.

While no one yet knows what the repercussions may be, everyone agrees on one point: we are at a unique time in history. Brexit, Trump, questions over the European project with key elections in 2017 alongside the emergence of new regional powers such as China and Russia: From a geopolitical perspective, 2017 is set to be both a pivotal and challenging year, not just for emerging markets bonds, but for us all.

Sergey Dergachev is senior portfolio manager at Union Investment