Populism’s Impact on Emerging Market Bonds
Author: Tristan Sones
May 17, 2021
The history of Emerging Market (EM) debt is full of attempts to implement more market-friendly economic reforms, hiking the hopes of bond investors only to be disappointed when political change disrupts or reverses that path altogether. The typical flow of events goes something like this:
A government spends and borrows beyond its means to the point where its debt is unsustainable. A pragmatic, market-friendly reformer manages to get elected and, working with the International Monetary Fund (IMF) and/or other multilateral organizations, develops a plan to get the country’s financial house in order and put its debt on a more sustainable path. This usually involves some combination of debt restructuring and fiscal austerity measures. However, correcting these imbalances takes time and the measures prove too onerous for the country’s people, many of whom neither saw the benefits of profligate borrowing in the past nor believe they will see much of a payoff from austerity in the future. So, when the next election rolls around, the disenfranchised vote for change, often in the form of a populist who promises the moon while thumbing the nose at agreements put in place under the prior administration and to bondholders and the debt overall. Economic prospects dim, debt balloons even more (or defaults), and global investors flee – until, at least, the next potential reformer comes along, and optimism rises once again. Rinse and repeat.
It is a familiar script, but not a wholly accurate one. Populism was a political force in many developing countries long before the recent rising tide that has enveloped much of the world, the West included, but the cycle of debt-and-destruction has not always played out. For instance, Chile, since the early 1990s, has largely managed to keep debt under control and maintain a consistent fiscal framework. In Brazil, in the early 2000s, the election of President Luiz Inácio Lula da Silva on an anti-IMF platform sent global investors running for the hills, but Lula surprised them by being more centrist and eventually paying back the IMF (helped by strong global growth and a commodity tailwind). More recently, Egypt has attracted significant global investment, as its IMF-backed economic program has been successful so far. In fact, Egypt is one of the few economies that likely grew in 2020, despite the pandemic, according to Bloomberg.
Clearly, the relationship between politics and economics in Emerging Markets is a tricky one, and the rise of populism globally makes for a more volatile and clouded landscape. Yet while the risks are real, so are the potential opportunities for fixed income investors. Bonds whose value is suppressed by political concerns might offer significant price appreciation should those concerns be alleviated or prove unwarranted. As well, many developing economies are highly exposed to the global economy and may be positioned to take advantage of a post-COVID recovery. In today’s environment, with yields low and spreads between bond classes tight, it makes sense for fixed income investors to have the flexibility to consider some EM bond exposure that might take advantage of situations where politics and economic reform are in play.
With debt levels high and the impact of COVID still significant, such opportunities should unfortunately not be hard to find. Yet it is important to remember that they can go either way. Case in point: Argentina. In 2018, President Mauricio Macri – backed by what was then the largest IMF bailout in history – undertook an ambitious program of fiscal restraint and structural renewal that generated enthusiasm among global debt investors. But Macri’s austerity measures proved too much for the electorate and in late 2019, he lost the presidency to centre-left populist Alberto Fernandez. Since then, the fiscal deficit has worsened, and the Argentinian peso has tumbled. The country last year defaulted on its sovereign debt – for the ninth time in its history– and today its bonds trade at approximately 35 cents on the U.S. dollar, according to Bloomberg. Meanwhile, foreign currency reserves are near zero, compounding the ability to navigate around their obligations and making it extremely difficult, if not impossible, for Argentina to make debt payments to the IMF or anyone else.
From an EM bondholder’s point of view, Argentina’s predicament might seem all too familiar. But it is important to avoid painting all Emerging Markets with the same brush, even where economic interests are contending with a populist resurgence. Prior to its presidential elections this year, Ecuador had restructured its debt and President Lenín Moreno’s commitment to fiscal responsibility better positioned the economy to take advantage of the recent rebound in global energy prices. (Ecuador is a net oil exporter.) Yet Moreno did not seek re-election this year. And after Andrés Arauz, a left-wing candidate who initially promised to tear up the IMF-backed austerity plan and send a $1,000 cheque to one million families, won the first round of the election in February, it looked like Moreno’s reform path would prove short-lived. However, in the run up to the second round the more centrist candidates joined forces pushing centre-right candidate Guillermo Lasso to a surprise victory in the runoff. Investors took notice. Short-term Ecuadorean bonds, which had been trading in the US$50-dollar range following Arauz’s primary win, rallied to more than US$80, according to Bloomberg. That represented a 50%-plus return for any investor courageous enough to have bought just after the primary.
Now, Peru looks like the next developing economy to face an “Ecuador moment.” A far-left candidate, Pedro Castillo, who among other populist measures has promised to nationalize Peru’s natural resources, surprisingly won the first round of the presidential vote in mid-April. The second round, set for June, will likely pit the former teacher and union activist, whose party has embraced the legacy of Fidel Castro and Hugo Chavez, against Keiko Fujimori, the daughter of former right-wing president Alberto Fujimori, who is now in jail for corruption and human rights abuses. Polls initially had Castillo with a wide lead, causing Peruvian assets to fall sharply. More recent polls have narrowed Castillo’s lead, but the uncertainty and somewhat binary outcome of the runoff is keeping downward pressure on Peru’s currency and bonds.
Whether that presents an opportunity for investors, of course, depends on a host of factors, the most obvious being the outcome of the June 23 runoff. Could Keiko Fujimori pull off a come-from-behind victory like what happened in Ecuador? And if Castillo wins, might he prove to be more moderate in office than on the campaign trail, à la Brazil’s Lula? He has already tried to verbally ease some investor concerns by distancing himself his party’s more radical views. Time will tell. (It usually does.) Bond investors will certainly be paying close attention.
Argentina, Ecuador, and Peru are examples of the current conflict between populism and more market-friendly policies in Emerging Markets. With debt levels high and more than 100 developing countries already turning to the IMF for support in the COVID-19 environment, more of these examples, unfortunately, can be expected. As such, a carefully considered and measured exposure to some of these stressed EM countries within a fixed income portfolio may generate returns either through outright capital appreciation in the short term or a more stable coupon in the longer term. The risks, however, can be high, and it is important to be thoughtful and avoid bias. It is too easy for some global investors, from their relatively privileged positions, to look at more populist movements in developing countries and assume people would not vote for policies that run so transparently counter to their long-term economic interests. Only those who live in these countries know the true hardships they are faced with, which might include losing a job or a pension or some other benefit for the sake of fiscal responsibility and its nebulous long-term payoff. It’s also not just frontier or emerging countries that are witnessing this internal dynamic. With widening income gaps, developed countries have also seen a rise in populism which has resulted in increased spending and a narrowing of the fiscal discipline between developed and developing economies. This trend is likely here to stay and has only been magnified by the pandemic; when assessing opportunities, investors would do well to be aware of it.
Tristan Sones is Vice-President and Portfolio Manager, Co-Head of Fixed Income at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
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