Fixed Income Fund Strategy: Striking Oil

Following our previous Insight, titled 'Buying the dip: value in Emerging Markets', we explore where we see value amidst the volatility

With the April sell-off in Emerging Markets a catalyst, the spread of EM debt to US Treasuries is now larger than that of US High-Yield debt for the first time since 2005. This re-pricing has created an attractive entry level for investors, despite continued geopolitical risks such as; (1) the risk of a Trump-inspired trade war, (2) the slow-down of the Chinese economy, and (3) the strong dollar combined with higher US Treasury yields.

The below chart shows the spread against US Treasuries for both the J.P. Morgan Emerging Market Bond Index (EMBI) and the Bloomberg Barclays US Corporate High Yield Bond Index, since January 2010. Since the global financial crisis, the EMBI spread has increased by 28% whereas the US HY spread has narrowed by 40.3% versus US Treasuries.

The Spread to US Treasury Curve of EMBI vs US HY Index

Spread to US Treasury Curve of EMBI vs US HY Index

*United States Treasury. Source Bloomberg (as at 23/07/2018)

Whilst re-emphasising our view that the EM categorisation is inappropriate due to the diversity of constituents, we note that, in general, fundamentals (such as current account & balance of payments) look superior relative to 2015 during the last major sell-off. To this point, we are selectively bullish in those economies with strong fundamental characteristics and, despite double-digit yields, we continue to avoid betting on distressed situations such as Argentina and Turkey.

In addition to our current EM positions (Brazil, India, Indonesia and Mexico), the Waverton Global Strategic Bond Fund (“WGSBF”) has been increasing its Middle-East exposure over July. On the whole, we believe that the GCC (Gulf Cooperation Council) region represents good relative value, underpinned by; a recovery in oil prices (as shown below), improving fiscal & external balances and high corporate credit quality relative to yields. More specifically, we view Saudi Arabia, UAE and Kuwait as having the most upside in contrast to Bahrain, from whom we steer clear on a fundamental basis.

ICE Brent Crude Oil Price (USD/bbl)

ICE Bent Crude Oi Price (USD/bbl)

Source: Bloomberg, Morgan Stanley Research (as at 23/07/2018)

Our view of oil is driven by; the supply risks in Iran, Libya & Venezuela (offsetting growth in the US), the continued drawdown of global oil reserves (in June, OECD inventories were 23 million barrels below the five-year average[1]) and the incentives for OPEC to keep prices high. As our outlook on oil remains positive, we expect an upswing in investment and a recovery in economic activity, translating into strong economic growth for the GCC economies. In parallel, structural reforms should boost non-oil related activity as economic diversification progresses.

Targeting investment grade corporates, the WGSBF has already invested in Abu Dhabi Crude Oil Pipeline (a subsidiary of Abu Dhabi National Oil Company (ADNOC), the producer of 3 million barrels of oil per day, which is over 3% of Global production) and Aabar Investments (a subsidiary of the Abu Dhabi sovereign wealth fund). Both of these companies are state owned and, as such, benefit from an implied support from the Emirate of Abu-Dhabi (AA credit rating), whilst having an attractive spread over the sovereign debt. We believe that the yields on offer in these names are attractive relative to the risk being taken.

By James Carter

 

Risk Warnings

The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions.  The information provided does not constitute investment advice and it should not be relied on as such.  All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.

Changes in rates of exchange may have an adverse effect on the value, price or income of an investment.

Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise.  Capital security is not guaranteed

The information relating to ‘yield’ is for indicative purposes only.  You should note that yields on investments may fall or rise dependent on the performance of the underlying investment and more specifically the performance of the financial markets.  As such, no warranty can be given that the expressed yields will consistently attain such levels over any given period.

 

[1] Source: International Energy Agency, 2018