"We remain bullish on emerging market debt": Q&A with Eaton Vance's Bradford Godfrey

We remain bullish on EMD and expect 2019 to be a good year for the asset class. There are a number of reasons for this view:

* An improving macro backdrop. The Federal Reserve has moderated its tone and is now likely to be on hold this year. China has just announced a stronger-than-expected burst of fiscal stimulus as part of efforts to manage its growth slowdown. We also think the Trump administration, in the lead up to the 2020 elections, is likely to focus more on domestic issues, easing back on its hard-edged international stance that in 2018 included sanctions against Russia and intense political pressure on Turkey;

* Country fundamentals in the developing world are now showing slight improvements at the margin following a few years in which they have been stable or deteriorating overall; and

* Investor flows and interest in EMD has been improving. Year-to-date (as at 28 March 2019), almost US$35 billion has come into the asset class, according to JPMorgan's estimates.

Eaton Vance's emerging markets debt (EMD) team turned bullish on EMD towards the end of 2018 and we were not overly surprised by the strong showing of the asset class in the first three months of 2019. Over the first quarter, the JPMorgan GBI-EM Global Diversified (local currency debt) rose 2.92% in US dollar terms, the JPMorgan EMBI Global Diversified (external sovereign debt) gained 6.95% and the JPMorgan CEMBI (corporate debt) was up 5.15%.

Views are as at 17 April 2019

We think it very likely that the administration will turn its attention inwards towards domestic issues as the 2020 elections come more and more into focus. Remember, President Trump came to power largely on promises about the economy and putting America first. We think the administration will start looking for wins that are more market positive. In the run-up to the election, the President wants the US economy to be doing well. The economy is very likely going to be one of President Trump's key talking points, possibly his key talking point.

With regards to China, we believe the relationship between China and the US is still in a structural decline. However, the tone and talks between the two countries will, in our view, become more constructive on a 12-18 month view. Our team is of the view that President Trump wants to make a deal but will seek to thread the needle of striking a deal while still looking tough on China and on trade.

While we continue to see modest downgrades to expectations - including the IMF's - EMD markets should be able to continue to perform. That said, the main risk for EMD is a notable slowdown in global growth.

The other main risk is the unpredictability of the Trump administration. We saw this in 2018: the administration's behaviour was at times challenging for various emerging market countries. It's something we are continuing to watch closely.

As noted, we think global growth will hold up and be in a range where emerging market economies can do well and their assets can also do well. The US is maybe seeing moderation in growth towards 2%, but that is still a pretty good number. In Europe, growth is slowing more rapidly and that is concerning, although some of that could be down to industry specifics. We take some comfort from the fact that the slowdown in Western Europe is not fully translating into Eastern Europe. In China - always a difficult country to read - policymakers have already added another bout of stimulus and more seems likely to be on the way in an effort to bolster the economy. Bottom line, we don't think the potential for weaker global growth undermines the positive outlook for the asset class. That said, looking out over the medium and long term, the policies of EM countries will, in our view, be the most important factor for the asset class.

As part of our investment process, we break down EMD assets into their respective risk factors; the components that drive the performance of the different types of bonds. As you can see in the simplified chart below (Exhibit A), we have a moderate overweight stance on the three risk factors relating to sovereign assets and are neutral on EM corporates. A moderate overweight view is unusual for us as an investment team - as debt investors we tend to be cynical by nature! So while it probably doesn't sound all that exciting, for us it's quite a bullish stance. In terms of expected returns, investors can expect returns to be commensurate with the type of risk you see in the EM space.

Source Eaton Vance. Views are as at 17 April 2019 and are subject to change. For informational use only and should not be considered investment advice.

Over the past decade, structural improvements in the EM space have been accompanied by a structural decline in inflation expectations. In the first quarter of 2019, consensus expectations among economists surveyed by Bloomberg for headline CPI over the next 18-30 months showed yet another leg down, from 3.16% at the start of the quarter to an all-time low of 3.04% (as at 22 March 2019). 1 To put that in context, in October 2008, inflation expectations were around 4.5%. This trend is clearly supportive for local rates.

When thinking about interest rates broadly, there is still a material difference between real yields in the EM space versus a developed market (Exhibit B). Although real yields are not as screamingly cheap as they were towards the end of 2018, there is still a reasonable differential in real yields between the emerging and developed world with room to compress. In our view, and combined with falling inflation expectations and the potential for policy improvements, investors are being rewarded for taking that risk.

1 Data is the equal weighted average of headline inflation expected in 18-30 months by economists surveyed by Bloomberg, which includes all countries in the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified, except Argentina. Data provided is for informational use only.

Source: Bloomberg, J.P. Morgan and Eaton Vance. As at 22 March 2019. Real yields are calculated as nominal yield minus headline inflation expected in 18-30 months by economists surveyed by Bloomberg. Excludes Argentina, Turkey and Romania.

One example is Bahrain, a country we became bullish about late last year. Bahrain is embracing fiscal reforms to help reduce the budget deficit and is getting financial support from neighbour and partner countries like Saudi and UAE. We're also seeing Bahrain being added to the EMBI, which will be a tailwind for their assets as investors that more closely track the index will have little choice but to add to those bonds, to buy their bonds.

Another country where we're seeing improvements is Ukraine. Volodymyr Zelenskiy won the presidential race in a landslide victory on 21 April 2019. A TV personality and comedian by background, he is certainly reform minded and we think he represents the best chance to fight corruption in the country. Ukraine is a country that is coming out of a crisis. It is growing again and its policies are likely to be orthodox. Once the parliamentary elections are out of the way later this year, we expect it will be a case of back to business with reforming the economy.

I should point out that when we talk about fundamentals starting to improve, we're thinking about what we're seeing across the 100 or more different EM countries that we research. However, because the EM universe is so diverse, there are also countries where fundamentals are still weak or deteriorating.

Three that spring to mind are Ghana, Zambia and South Africa. In the case of Ghana, there has been some consolidation in the finances but we don't think it has gone far enough. Also, right now in the local markets in Ghana, some foreign investors are experiencing difficulties in exiting the currency. These investors will likely continue to weigh on the market as they try to repatriate coupons and sell their bonds.

Zambia is headed towards debt distress. Spreads are quite wide, the authorities don't really have access to the market right now and for almost two years they have been struggling in their negotiations with the IMF. Right now, it appears that they're renegotiating their obligations with China. Once that runs its course, there may be no other option for Zambia but to have a discussion with their commercial creditors.

South Africa is a country that we've been structurally bearish on for quite some time. It is really struggling to grow. It doesn't have a viable growth model and this is exacerbating long-term social issues in the country.

Looking ahead to the upcoming elections in South Africa, there is wide expectation that the African National Congress (ANC) will win again and that Cyril Ramaphosa, the president of the ANC, will be re-elected as the country's president. In our view, President Ramaphosa and his team do not have the policy prescriptions to restart growth and so expect more of the same. The challenges facing South Africa are deep and widespread. We're starting to see stories of corruption touching people close to the current president, including his family.

The country examples I've mentioned (positive and negative) hopefully highlight the non-homogenous nature of the EMD universe. So yes, fundamentals are improving slightly overall at the margin, but the real opportunities are very much on a case-by-case basis. At Eaton Vance, we always make the point that it is essential to pick the right countries and risk factors. We also like to make the point that, in order to get the most out of this asset class, it is important to research and select from the broadest possible investable universe; not simply the limited universe of a benchmark index.

Absolutely. At Eaton Vance, part of our investment analysis involves thinking about the management team and whether the structure is in place for them as well as if the incentives align. In the case of sovereign bonds, I'm of course referring to the government. Specifically, we consider questions like the calibre of government leadership, their underlying policies, their philosophy when it comes to economic policy, as well as fiscal, monetary, income and trade policy.

Overall, policy forms the crux of our analytical focus. That said, many developing countries are richly endowed with natural resources. We want to understand how they are utilising their natural resources and whether it is sustainable, as often this will be important to the overall economy.

Obviously, having a good government that can better support economic growth as opposed to a bad government, which can be a detriment to economic growth, is important to the social framework of a country. There is a lot of research to demonstrate that countries that implement more liberal economic policies tend to be the most effective at sustaining and supporting long-term economic growth. The evidence shows that this also comes along with notable social benefits, such as lower rates of child labour, domestic violence, cleaner water and others. All of these factors are very important when investing in general, but this is particularly true within the emerging markets space.

Sources of data: Eaton Vance, JP Morgan and Bloomberg. Date of Data: 31 March 2019 unless otherwise stated. Past performance is not a reliable indicator of future results.