Welcome to the Q3 2024 Performance update for the Vanguard Emerging Markets Bond Fund.
This top performing fund continues to deliver consistent alpha, outperforming on average by 4.3% per year. The fund is not only top quartile in every single calendar year, but has also outperformed its prospectus benchmark in every calendar year as well. Joining me, as usual, is Nick Eisinger, Co-Head of the EM Fixed Income Active Team.
Nick, perhaps we could start by thinking about the macro with a 50 basis point cut from the Fed, their view of a disinflationary environment, and lots of other events, including stimulus from China and other things. So what's your view of the events of the quarter?
Thank you Andy, as always. The Fed has really been the main event for risk markets over the past several weeks. As you highlight the 50 basis point cut, with a good probability of more to come, perhaps not quite as much to come as the market initially priced in, but nonetheless an easing cycle. That is usually pretty positive for emerging markets. And we've seen that certainly reflected in absolute returns. Spreads, however, so the credit component of emerging markets have been a little less lacklustre. That doesn't mean to say they haven't rallied, because they have in general. But really, what has stolen the show, for the past quarter at least, has been what's going on with core global bond markets.
And so the asset class return, 6% over the quarter is obviously very healthy, helping investors with their portfolio returns overall. The performance of fund was flat. You know, from an alpha point of view this quarter obviously still positive, year to date. And what were the drivers?
Because that flat performance is going to hide some good news stories and some bad news stories. Sure. So at a very high, attribution level, we made money in the quarter on emerging market rates or duration. A lot of that was unfortunately offset by the incorrect calls that we made in call duration. And if you think about our positions in call duration, there's two real factors here. One is taking explicit views on the Treasury bond curve, and the other is an implicit position that you have by virtue of either owning or not owning certain, treasury sensitive, parts of the credit market. and so ultimately, we were a little bit exposed to the very, very strong Treasury rally that we had. And I think that partly explains some of the more flat performance, as opposed to the much more positive performance that we've had in more recent months and quarters. I would say another area, is we lost a little bit of money or we were a little bit under risked in some of the frontier special situation funds, or situations. So here we're talking about some of the countries that have been exiting debt restructurings. So we made plenty of alpha on the way down because we recognise these countries in a year or two, or even three years ago were, in a very difficult situation. We bought some of that risk back, pretty much at the bottom. And we probably sold that a little bit too early, in the context of the restructuring. So to give two specific examples, the restructuring we saw over Ukraine, we felt would be much less generous than ultimately proved to be the case. So we've actually, since that, added back a little bit of Ukraine exposure, in certain parts of the new bond curve. And we were also probably a little bit under risked in Ghana, which has very recently concluded its new bond restructuring. And again, we felt back then, that was being priced in was, you know, more than what the government was ultimately going to give the market, and we were correct in that assumption. But the market has been tremendously bullish in the early stages of the new Ghana trading environment.
And you've recently wrote a paper, you know, going through these special situations and their new structures. So the you know, the VRIs versus the more traditional structure that Ghana went with. So I encourage everyone to read that, we'll make sure we send that through with the update as well. Looking at deeper some of the stories within the quarter, you know, oil fell 20%. Oh, it's biggest fall ever. But it's still relevant for EM issuers, some of which, you know, they import oil so they enjoy a fall and other ones export oil. So how do you play that, sort of, you know, macro directional and make sure that doesn't throw the fund around?
Well, as you said, it's both sides of that ledger. So oil is always a big risk factor for emerging markets, for the macro reasons you just outlined. So you can think about this again at a high level of low oil price is generally going to be beneficial for countries like Turkey, which typically is a net energy importer, as well as a country like Egypt. So that's important because those are two very big components of the credit index. And on the other side of the docket, it's going to be less positive for perhaps a country like Angola, which has a very, very high beta, or high sensitivity to the oil price. And obviously a number of other countries, you could think about places like Ecuador, you could think about countries like Nigeria as well. And so we have probably had more of an overweight, constructive position on the countries that benefit from the oil reduction. We've been a bit more cautious on the other side. So, for example, we have maintained underweight in countries like Nigeria. We're beginning to change that because we do think there's some idiosyncratic, specific developments going on there. That could be very interesting for bond holders. And Angola we've really sort of, if you like, traded on a more tactical basis because we understand that is pretty much pure oil, basis when oil falls, you know, you want to make sure that your, allocation to Angola is low enough that you can add to your existing positions. We had a small position, oil prices fell, we added to that position. Oil prices have rallied subsequently. And we're now in a bit of a team debate as to how we play going forward. The Angola, for example, versus Nigeria, relative value. And I guess is where you can play the curve, you know, within a country because this is an area of, you know, consistent alpha that the teams' generated, not just, you know, choosing the right country, but, you know, going short when you want the short and going long when you want that. For sure. And we've been doing that a lot, right across our portfolio. But if we stay in the African continent, for example, some of the countries that have, you know, been seeing a bit more negative news flow recently, I'd point in particular, to say a country like, Senegal, and then, you know, a little while ago, Kenya, some fiscal problems. Senegal was about to have an election in November, they have uncovered a set of much worse fiscal data than the IMF was telling us, even under the program that existed. But what you've had there is you've had a big flattening of the credit curve, meaning that investors start to get more concerned about the near-term prospects of a country like Senegal. And we like these kind of situations when different bonds move, within the same issuer, because, as you say, it allows us to play some very interesting relative value in security selection trades. So Senegal again, to use that example for us, despite its problems, this is not a country that we see as a default candidate for the foreseeable and most likely the long term future actually, and so we will be able to take advantage of a much flatter or even inverted yield curve, because our view relative to default for that country is very different to what I think the curve has been pricing. And you mentioned the IMF. You know, you in DC next week, you know, with the IMF, how do those interactions help you get more colour on the ideas in the portfolio? So the interactions, are beneficial on a number of fronts. The first one is it's simply efficiency because you're able to see 40 issuers within the week. You wouldn't be able to do that if you had to fly to 40 different countries. That would take you a lot longer than a week, I imagine. And it's particularly useful, some of the smaller countries where perhaps the data isn't that, well, disseminated, perhaps it's not that well covered. So I'm thinking about countries, for example, such as Gabon, such as Bahrain, where it's much more useful to have that interaction with ministers and then with the IMF officials as well. So that's the second big advantage. And the other real advantage, to me at least, is you get a really good sense and colour of what other investors are thinking about the market. So we like to say in our team, the IMF is a very good contrarian indicator. So we try to debate what we think the themes going into the IMF will be. We try to position the portfolio a little bit tactically for that. And then usually what we do when we come back from IMF meetings and there's a big consensus in the IMF, we will, where possible and where sensible, take the other side of that. And usually that works quite well. Coming up a level that the funders delivered, you know, double digit returns over the last 12 months that the, you know, the benchmark asset class a little bit less, you know, that's attracting investors. How do those technicals, because you're going to have invested demand in aggregate, how does that marry issuance at the moment? So issuance certainly in the IG space this year has been pretty strong. I would say that hasn't really made too much of the difference, a negative difference or drag to performance, issuance in the high yield space. Again, because we did have volatility in the early stages of the year, you know, before obviously the Fed started to cut, we obviously still have questions over the state of certain macro pockets across the world. We may get on to China in a moment. So high yield issuance in general has not been particularly prolific. So overall, I would say the technical factors from a pure supply and redemption of bonds in emerging market credit has been pretty good. Now we need to overlay that with what's going on at the broader asset class level or even at the broader fixed income asset class level. And most latterly, we've seen some pretty encouraging flows coming into the market. A lot has been going back into China, China equities, for example, but we have seen a decent amount of flows coming back into emerging market fixed income, both hard currency, and to a large degree in local currency. And if we think about how decimated flows have been over the past three years, really, we believe that, you know, there's plenty of room for catch up. And that's really why we think investors, you know, have good reason to be quite excited for 2025 because although spreads are tight, although clearly there are macro risks at a global level, and for emerging markets, it doesn't mean the yield and spreads cannot overshoot, because if the flows start to come back in, a lot of ETF flows as well. We can see a pretty, you know, productive year going into 2025. And combined with 7% yield, you know, it's, you know, it's healthy for sure. So, the big fanfare around the stimulus is really, in some ways the boy that cried wolf. So we were promised plenty of stimulus, potentially very large stimulus. And so far it's been a little bit disappointing. That doesn't mean to say that are not important things happening around the periphery, around the edges, particularly with regard to some of the local government funding situation. And I do think that the authorities have some plan in mind to deal with, you know, the very damaging second, third round effects of the real estate market. So it seems to us that the Chinese authorities are doing enough to ensure that perhaps the situation stabilises. I think it would be fanciful to take a view that they will suddenly start to be growing at 6 or 7 and become a very big, important engine of global growth as they were a decade or so ago. But to be honest, all we want is stabilisation.
We just don't want China to continue as this drag on global demand, and global risk. So in my bucket, that's a glass half full rather than a glass half empty. It may also be, more of a tactical consideration by Beijing. So it may well be that they're, preserving some dry powder, as we like to think about it. And I mean China's not a huge part of the hard currency, you know, asset class. Anyway, the US obviously isn't by definition, but both of these stories are important. So how are the, you know, have the emissions dried up in advance of that or how are central banks thinking about that? Sure. Issuance has continued, particularly in the high quality bucket, or in some of the countries where the macro story has been very positive this year. So Turkey, for example. We've seen plenty of issuance from the Turkish sovereign, from many Turkish banks, many Turkish corporates, high yield less so. So our view is fairly constructive on EM risk overall. Let's move from, you know, things are important but not part of the index, to things a big part of the index. So perhaps we could quickly cover off in Turkey, Mexico and Egypt and how you're positioned. So Turkey's been one of the big macro success stories for 2024. And we think and hope that will be the case going into next year as well. So we've had a big normalisation of monetary policy. Interest rates are now 50%. Turkey's actually a contrarian indicator in that sense, because all other central banks have been cutting rates. While Turkey, by large has been, hiking rates quite aggressively. It was very necessary for them to do that, given their legacy. And this more normal policy environment has really meant, that inflows and the rebuilding of foreign exchange reserves, which is a very important indicator that we look at for credit worthiness of a country, has expanded enormously. So the whole credit situation in Turkey from being in a more precarious position maybe a year and a half ago, is now very stable, quite robust. I would argue a lot of that is already reflected in the credit spread or the CDS spread, but there's probably more to go as they move to the next level of normalisation. The other trade that's interesting is what we call the carry trade. So that's, pure and simple Turkish Lira carry trade short term, that's a trade we've been involved with. The Lira has been appreciating in real terms. They've been using it at the central bank as an anchor against inflation. And that's been a very successful trade. Quite crowded, so we need to be a little bit careful about sizing of positions. But a trade we still like. The trade for next year is potentially the duration trade. So in other words, you're buying longer duration local bonds. And that is a trade that some have been involved. That hasn't really worked because inflation is coming down, but at a slower level than initially expected and therefore the central bank cannot cut rates at this stage. And you really need that inflation cycle to fall. And the expectations of a rate cut cycle to follow from that for those trades to start to work. We think that's something that will happen in 2025 and we will Position ourselves for that. But we're not really in that trade per se at the moment. You might not bet the House on it because oil might bounce back up and then you’re back where… So it's good to see them having a more conventional approach. Yes. But also Mexico has its own idiosyncratic factors going on with the election and the inauguration now of the new president, kind of shy, and some of the changes that are taking place at the Constitutional Court level. Investors generally don't like that. Investors consider that to be a slow but gradual deterioration in some of the institutions of Mexico. And remember, Mexico is a big part of the index, and it has very, very solid liquidity across all of the emerging market asset classes. So that will include equities, that will include the currency, local fixed income and obviously credit, and then a whole range of other names like Pemex etc. it got to be a very crowded trade. The summer unwind of some of the Japanese Yen funded MXN carry trade off the back of the political developments, I think made people open their eyes a little bit more to some of the vulnerabilities. So the fundamental situation is still good, but it's still very heavily positioned. And another area we've talked about in previous quarterly updates, Egypt. Yes. You know, they’re still a very, very complex part of the world you know, how is that played out and how are you positioned. It's played out well. We are overweight sovereign credit, pretty much right across the curve, probably with a preference for the long end. Egypt has, you know, maintained a pretty strong relationship with the IMF since the, for many years, really. But obviously the IMF came back and signed off on the latest series of disbursements earlier this year. Clients will also recall that that was pretty much perfectly timed, with the very sizeable 35 billion plus dollars of investment from the UAE that came into Egypt, for foreign direct investment, tourism development. Some of that was existing money in the form of deposits that simply got converted and some of that was new money. So that's really boosted their near-term foreign exchange liquidity and therefore credit worthiness. And almost as night follows day from the Gulf. The Saudis want in as well. And so, we've known at the back of our minds that the Saudis are going to try, at least to partly match what the Emiratis are doing. And we heard just this week, for example, news of sort of anything between 50 and 20 billion potentially coming into Egypt. So that maintains the story. Egypt's macro situation it still has plenty of imbalances. It continues to run a big current account deficit, has a big funding need, but it has the money for the time being. Debt to GDP is still in the high 80%, so that's still high. These things do need to be addressed in the context of the IMF program. And then, more of the double edged sword for Egypt, is obviously its geographical location, for obvious reasons. You know, there's downside for what's going on. Things like the Suez Canal receipts have dramatically fallen. Tourism, surprisingly, has held up well, but on the positive side of that ledger, I think the international community, including the US, including the IMF and including the Gulf countries, understand that Egypt cannot be allowed to go into financial failure at this very delicate geopolitical situation. And as mercenary as that may sound, that's good for investors in that country. And they've gone from exporting gas to importing gas as well, so they're on the other side of that, their energy store as well. Let's do a, let's do a quick fire round, for a few countries. Sure. So start with Venezuela, how is the fund position? Venezuela. Venezuela is yours, my friend. No, no, no, no holdings of Vene was an interesting one because it came into the index. There was a lot of sort of technical stuff around it. There was this great hope that the elections earlier this year would go well, and that would be the overture to a debt restructuring. So people didn't want to miss that opportunity. That's simply not happened. So you let. So being as short as you can, Venezuela, I think, remains sensible. Let someone else take that risk on, so Argentina? Yes, we like it. You'd have to argue a lot of the good news is priced in. But the administration continues to surprise on the upside on the fiscal side, I think the relationship with the IMF remains pretty cordial. So we think there's still, you know, a decent amount of upside. Probably a large portion of that has happened already. But we continue, to hold overweight positions there. The next big trade actually in Argentina will be local. But we need to see more developments on the lifting of the very sizeable exchange in capital controls before we can get comfortable, to do a trade, in that space. Maybe that's next year. Maybe not. But something we're looking at, too. And we've covered a lot of African a lot of LatAm countries. Let's quickly go to emerging Europe, Romania, Bulgaria. Are they the same story with failure to join the Euro? I mean at the same store in as much as there next to each other. But they are two countries whose fundamentals are actually diverging quite meaningfully. So Romania still investment grade, just, surprises me sometimes. But they continue just to have very large fiscal indiscipline. The deficits continue to rack up. We are also, you know, approaching elections in Romania. So that's potentially one reason why the deficits can't necessarily be addressed at this case at this stage. I'm sorry. But that does continue to go up. So that's a market where, you have to be tactical. It doesn't mean you can't make money out of that market, but you need to be careful with your position sizing. You need to be very, very aware of technical factors, because we know that Romania will continue to issue as many bonds as they possibly can, partly to take the pressure off the local market. So we'll contrast this with Bulgaria. Very low debt levels, probably under 25, 30% of GDP. Obviously already a member of the EU. And a country that I don't want to say almost certainly, but has a very high likelihood of being the next candidate to join the Eurozone, that was actually meant to be happening this year. There was a few delays for inflation and technical reasons. And this is also a country that seems unable to form a government of any stability. Not that that necessarily matters. Now, obviously spreads are very tight. But then the next big thing for Bulgaria will not be the fiscal stuff that we're looking at in Romania, but it'll be really the time flow and the context with which they join the eurozone. If it's the end of 2025, as we currently anticipate, there's still money to be made, in having positions, in that name. So following Croatia as the next remember that club. So perhaps you could give us your thoughts on the outlook for EM for the rest of this year and beyond and perhaps touch on some key elements as to why investors should consider holding this fund or continue holding this fund. We're still in a situation where the Fed is cutting. Now, it's probably not cutting as aggressively as some, had been pricing in, but it's still cutting. And almost by definition, as the Fed cuts everybody else is cutting. There's room for countries to do that. And history tells us that, you know, when that cycle starts, generally speaking, risk assets perform quite well. The caveat to that, of course, is what happens at a macro level. In other words, global growth. That's why we take some comfort in the, we talked about it earlier, but the mini stabilisation, if you want, that the Chinese authorities seem to be engaged in at the moment. And we also take some comfort at the fact that the data out of the United States continues to be pretty robust. The economy is not necessarily hot. But it's certainly not cooling down that quickly, at the moment. And then across the board, in EM, we actually see the economic activity, is, also quite resilient. So this soft-landing context, even if it's, you know, to a large degree priced in at a global level, is potentially very, very positive for EM, spreads can continue to compress. If you do really believe the soft landing story, we certainly think there's a lot more scope for compression in the more high-yieldy parts of the market. Again, you have to be careful with position sizing because if you're wrong and there is a big global recession sooner than thought, then some of those high yields that have been the best performers of the past 3 or 4 months most likely become the worst performers of the subsequent months. But it's all a matter of, you know, portfolio positioning, managing your risk correctly. So going into 2025, if we then have this flow story that we've been talking about, so we catch up on the three years of, the three lost years if you like, the flows, then emerging markets can really perform very well. Other fixed income assets will also be performing quite well. But let's not forget, emerging markets gives you, in our view at least much greater dispersion. In previous episodes of this discussion, I'm sure we've talked about, you know, you've got high quality names from the Emirates right through to, you know, the more difficult names, you know, CCCs like Ethiopia, countries like that, you get all sorts of different choices along the credit curve. That's very good for selection. And you get a lot of duration, so you get more spread typically than an IG in the same duration. You get similar levels to higher levels of spread than in the US, high yield, but you get plenty more duration than in the US high yield. So from a structural perspective, it's a great thing to own going into this soft landing context for 2025.
Thank you very much, Nick you know the skilled team, you know, delivering three quarters of that incredible 4.3% alpha from security selection, positioning for a resilience and the macro looking healthy and supportive alongside the technicals should be, you know, a good year for the fund, especially as he goes for his fifth anniversary. As well of this UCITS version. So thank you very much Nick.
Thank You.
