The third quarter was marked by increasing divergence between the improving fortunes of the developed world and signs of a slowdown in emerging markets, with a decline in unemployment in both Europe and the United States and an uptick in growth indicators.
Falling commodity prices, China’s slowdown and the prospect of higher US interest rates sparked intense market volatility throughout the quarter. Benchmark government bonds continued to register gains as investors sought safe havens and inflation remained subdued, but while corporate bond issuance remained buoyant, investors started to demand higher yields, relative to Treasuries, to own US corporate debt as the quarter wore on.
International investors removed money from emerging-market bond portfolios at a steady clip in anticipation of rising US rates, although a late-September decision by the Fed to keep rates on hold for the time being helped to steady nerves.
Overall, waning investor demand pushed borrowing costs higher for emerging markets and served to curtail issuance.
While GCC countries have been affected by weaker oil prices, as the outlines of a nuclear deal between Iran and the western powers opened the possibility of increased flows of Iranian oil on to world markets and helped to keep oil prices low, the Citi Mena Broad Bond Index eked out a 0.09 per cent return (in US$) in the three months to the end of September, outperforming the JP Morgan Emerging-Market Bond Index Global-Diversified.
The impact of soft hydrocarbon prices tended to be offset by strong foreign currency reserves, which enabled countries such as Saudi Arabia and the UAE to support their domestic economies through higher spending – although at the cost of sharp increases in budget deficits.
At the end of its periodic review of the region, the IMF issued several recommendations for countries to deal with the sharp drop in oil prices. For example, it called on Kuwait to impose a 10 per cent tax on foreign and domestic corporates alike. It also suggested that Egypt should introduce a flexible exchange rate, implement a value-added tax and further cut energy subsidies, and it recommended that Saudi Arabia reduce its bloated public-sector wage bill, as well as reduce domestic energy subsidies. While budgetary positions took a downturn around the GCC, government stimulus generally meant that non-oil economic activity held up well.
While continued uncertainty regarding the timing of the first Fed rate increase continues to affect market sentiment, market fears are creating attractive opportunities, whether the Fed decides to remain pat to the end of this year or whether it opts to raise rates during the final quarter.
A further delay in raising rates (such as was decided at the Federal Open Market Committee meeting on September 17) would represent a continuation of the expansionary monetary policy that has helped stoke growth for some time, while a modest Fed rate increase – possibly in December – would, in our view, remove the cloud of uncertainty that has been hanging over emerging-market assets.
To the extent that a rise in US rates would signal a confirmation of the fundamental strength of the US economy, we further believe policy “normalisation” in the US could actually help global (including emerging-market) growth.
The market’s current uncertainty is also fuelled by worries over the state of the Chinese economy, but here too, we believe it is reasonable to expect that the effect of a wide series of fiscal and monetary moves by the Chinese authorities will be felt progressively in the coming months and will contribute to improving global sentiment.
As for the GCC, we are encouraged by the reforms to ultimately unsustainable tax and subsidy mechanisms that the drop in oil prices has triggered throughout the region. While the authorities in many countries still have ample room to support their domestic economies, we are also pleased to see examples of ever-greater budgetary discipline in the Mena region at large, which should not only improve the creditworthiness of the region as a whole in the medium term but also help the development of its fixed income and sukuk markets.
Mohieddine Kronfol is the chief investment officer for fixed income and global sukuk at Franklin Templeton Investments (ME).
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