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- [00:00]
A
Today's Animal Spirits Talk. Your book is brought to you by VanEck. Go to VanEck.com to learn more about the VanEck Emerging Markets Bond ETF Ticker EMBX. That's VanEck.com to learn More.
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B
Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Rithol's Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.
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C
The following interview reflects the opinions of the speakers as of the recording date and may change without notice. The discussion includes forward looking statements and views about markets, economic conditions and investment strategies that are not guarantees of future results.
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A
Welcome to Animal Spirits with Michael and Ben. Michael, you learn something new every day.
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D
It's true.
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A
Today I learned on our talk with Eric Fine, who's the portfolio manager for the Vaneck Emerging Markets bond strategy, that in the past 10 years or so the volatility for emerging market bonds, emerging market currencies have all come down to now the point where they're lower than for developed markets. That's kind of shocking to me. I guess assumed that it was conventional wisdom that emerging markets were just always more volatile.
- [01:24]
D
Yeah, news to me.
- [01:25]
A
Very interesting stuff. I feel like the bond market is one area where people are just now this decade starting to explore other areas of it. Right? Because you had this thing where the AG or the total Bond Market Index fund or whatever got kind of blown up a little bit from the inflationary scare and the rising interest rates. So people are going whoa, whoa, whoa, I need to learn other areas. And emerging market bonds are one of those places where I don't think there's been a ton of exploration. And this is our first time talking about on the show too. We didn't know all the stuff about volatility currencies. Why emerging markets actually I don't know from a fiscal perspective seem better than the developed markets today. Which is kind of crazy to think about that they were such a basket case and just a series of crises for so many years. Anyway, fun conversation. Here's our talk with Eric Fine from Vaneck.
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D
Eric, welcome to Amylsperts.
- [02:22]
C
Thanks Michael.
- [02:22]
D
All right, so we are here today talking about emerging market bonds and to the extent that people do think about their bond allocation, they are probably thinking through the lens of United States bonds, be that government issued Treasuries or municipal bonds or corporate bonds, junk bonds, things like this. Rarely do they think outside the US and if, if they do, they are probably thinking about Canadian bonds or UK bonds or something a little something equally sort of plain vanilla. Rarely do they go out on the risk spectrum to think about emerging market bonds because historically they have a, let's call it a negative connotation as far as it pertains to the fixed income side of the ledger. How is that understanding or thoughts changed over time?
- [03:15]
C
Yeah, that's a great question, Michael. So em, as you rightly cited has a perception is perceived to be more risky. Set against this is the fact that EM bond volume is now lower volume than developed market bond volume. So that's number one. That's pretty hard for investors to argue with. When the volatility of a bond market is lower than another's, it's, you know, by most finance frameworks is considered less risky. So that's happened. Moreover, the carry is higher. All your coupons in your portfolio divided by the price. If nothing happens over the next 12 months at your carry is higher in EM bonds than it is in Treasuries or the AG for example, the most common flavors. So already if your volume is lower and your carry is higher, that's pretty much Finance 101. But on top of it, this has been happening for a long time. It's been happening for over a decade. The AG and Treasuries are barely are basically up zero over the last 10 years. Our benchmark's up two and a half, our fund is up a lot more. And now the perception is changing partly because the 6040 hasn't worked, but that's because people had the wrong 40. They're up to their necks and develop market bonds like the AG and Treasuries, which are generally characterized by governments that have too much debt. We can talk about what that means, but that's the story. Whereas the good 40 is countries that have low levels of government debt. They've already generated the lower volatility and higher carry.
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A
I guess the conventional wisdom is that emerging market everything, the stocks are more volatile, the currencies are more volatile, the bonds are more volatile. Why is it the case that that volatility has been lowered?
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C
The basic dynamic is the absence of fiscal dominance. So fiscal dominance is a movie that emerging market economists or bond fund managers have seen for decades. It's what happens when a government has too much debt. What happens is the central bank ends up not maintaining real rates as high enough as it, as high as it would otherwise if it was solely focused on inflation. And so you end up with higher inflation. We've seen this movie 80 times and many of the countries, I'd say most of the countries in our benchmark have learned the lesson to the point that it's not just about fiscal, it's now about politics. My countries have presidents or prime ministers with 60, 70, 80% popularity who promised maintaining budget stability, who promised maintaining an independent central bank. It is not popular among any parties in most of my countries to promise you're going to harness the central bank to achieve economic objectives. So it's not just the fiscal, right, the level of debt that allows EMS to be better and DMs to be worse, which is, we're seeing the evidence of it in the UK and Japan. But this has also resulted in really healthy politics where you're just not going to get a lot of these more risky economic ideas infecting EMs. They can't even afford to contemplate them. So they're actually a lot less risky.
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D
It's really interesting to say that. I mean, obviously a narrative violation with, with lower volume, higher, higher, higher yields performance. Another thing that has changed. So you mentioned like the political stability. That's not, that's not like. When I think about emerging markets, that's not what comes to mind on the equity side of emerging markets at the index level, it looks a lot. The composition in terms of the sectoral exposure looks a hell of a lot different today than it does 20 years ago. I mean a complete transformation could like completely. I wonder what the bond side looks like. Is the story similar?
- [07:14]
C
First, comparing EM equities and EM bonds, I would say the following. EM equities is mostly Asia and mostly commodities importers. Right? I mean you can frame these or aggregate the world however you want, but they're mostly Asian and mostly commodities importers. They are exporters of value added goods like chips and cars or whatever, but importers of commodities. EM is not mostly Asia. It's mostly not Asia and has a lot of as a majority of commodities exporters. So I'd say that's the biggest thing that's happened. Now continuing with your question, the big issue in equities is how big China is and what to do with it, which is an endless conversation. Should I have China X? Should I have J? I don't know. You can't go anywhere with that discussion. I don't know your problem. Right. Is the best answer so EM bonds though, have not had that problem. The indexes have always been capped. Both of our benchmarks have 10% caps per country. And there have always been more markets that are more diversified, a lot less concentrated in these few EM equities that are doing well. The last point I'll make is that within EM bonds, I'd say that especially with the local currency bonds, there's really two worlds. There are the, what you consider typical EM bond, let's say a Brazil with high beta, 14% yields, only 4.5% inflation, by the way, 14% yields. And there, that's higher beta. You have to treat it as the higher risk instrument. It is. But there is a whole category of my market that is being bought by central banks. And they're not going to tell you a big portion of our Asian bonds are becoming reserve currencies. And just as with gold, we wrote about gold 15 years ago, Central banks were going to buy it. No one cared then because it wasn't really a story. They are not going to send a press release to the Financial Times saying, oh yeah, we're buying gold over the next five years. Right. When you saw all those headlines of Brazil, China, et cetera, agreeing to trade in each other's countries, what do you think a bank or central bank is going to do with a bunch of cash? Right. They're going to open a bond line. They are not going to send a worldwide memo on it. And that's the big thing that's happening. So I think of China government bonds, Malaysian Ringgit bonds, Sing dollar bonds, Korean Won bonds. Those are attractive reserve assets to central banks that want to diversify. And so there's demand. So that's really unique at the time that they're selling the stuff that's in a lot of our portfolios, like Treasuries.
- [09:56]
D
So you mentioned your portfolio. You are the portfolio manager for the Vaneck emerging Markets bond strategy. The ticker is embx. Where does your work begin? Like, all right, you, you log on, you're looking at, I guess, currencies, interest rates, fiscal solvency or lack thereof. Is there investment grade stuff in here? It sounds like a giant and completely different universe than what the typical investor is used to looking at. So where does your work begin?
- [10:23]
C
Yeah, I think that's a fair description, which is also a great counter to any efficient market hypothesis. Right. I mean, the odds of me beating The S&P 500 are extremely low. Right. Just mathematically and, and with a less efficient market. So I'll start with that. So we have a benchmark, very old benchmark. That's where we start. What is our benchmark? Our benchmark are the two oldest government bond benchmarks in emerging markets. The oldest one is dollar denominated. These governments borrow in dollars and that is basically exactly like the US high yield or ignore market. You get a spread and if the spread compresses, you know that's good. If the spread doesn't widen too much, that can be good too if you like your all in carry. But it's very much like the IG or high yield market in the US with the exception being that in EM you get a little higher spread for the same rating and it's harder for the EM to get the same rating. So it's arguably better quality. But that's the dollar space fairly straightforward. And I don't like leading with the example because that by itself has done incredibly. I don't even want to say what it's done over the last 20 or 30 years. The spreads were really high. It was the first winner from fiscal. The absence of fiscal dominance was the first thing that rallied as the EMS got their acts together starting around 30 years ago. The other part of our benchmark is the same governments or different set of governments, but often the same governments and their bonds and their own currencies. And there they are generally higher beta, but these are all mostly much higher yielding with great success on the inflation front. So those are our two benchmarks. And we start with the benchmarks. We overweight things we like, we underweight things we don't like. And in extreme situations, because we're bond investors and it's all about being paranoid and avoiding losses, we're allowed to eliminate some things that are too risky, but we can't do that too much.
- [12:25]
A
How about currencies? That's kind of one of the risks. A lot of people say when you're investing international bonds is, hey, the currency that could kind of swamp our yield. If currency goes against you. How do you think about that? Do you guys hedge currencies at all or you let them free float and it is what it is?
- [12:38]
C
Yeah, great question. First, overall, FX volatility in emerging markets is lower than developed market FX volatility. So yen, sterling, Right. Euro, a dollar, though that's been the volume. The volume has not been Chinese Yuan, with which most of my countries trade, which has been like watching paint dry in a good way. Right. That's just getting stronger and stronger and stronger. So first, the volume is already lower. And second, as a general principle we never hedge currency risk because hedging the currency risk takes away basically the entirety of the value. The value is the yield. And we try to invest in countries with high real yields. So countries that pay you a very high interest rate in their currency, much higher than their inflation rate because their inflation rate should and will hurt their currency. But if they're paying a lot more than that inflation rate, their currency shouldn't go down. And that's what's been happening roughly for 10 years, especially in the Asians. And that's also why other reserve, other central banks want these sorts of assets. The definition of a reserve asset is not that when your interest rate goes up, your currency weakens. A minimum is that if you hike interest rates you can stabilize your currency. And the UK and Japan can't even do that, whereas EMs do do that all the time. They're arguably being too hawkish because of the Iran war now, which is why things have been so stable and EM has been a winner again year to date. Again, I don't want to make it sound like it all sounded this year as it's been going on for a long time.
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A
So you mentioned that a few times now. So you're saying a lot of these emerging market countries are buying each other's bonds.
- [14:18]
C
Correct. And they've got a lot of assets. These are the big reserve piles. Right. These countries, especially in Asia, own more of us than we of them. Right. Economists would call that your net international investment position. But look at their how many cgbs does the Fed own? Zero, I assume. May I know? Maybe some. How many Treasuries do Japan or China or Korea have? A lot. Trillions. And so we depend on the kindness of offshore. Right. We need to borrow a lot from offshore. If you regress US yields by this fact, we did this in one of our research pieces and say, hey look, let's just take into account the fact that we borrow a lot from overseas. Now why does that matter? Because a yen or Chinese based investors going to hedge their currency risk and because of the volatility, the yield on our bonds on Treasuries there is so much lower now that they're not buying it. And if you calculate that using a simple regression, it means our yield should be a lot higher. But that would be the economics way of explaining it is these countries have low debts, they borrow onshore, they have to work to raise their their money. And the US generally just pushes a button and assumes offshore investing. But obviously since the 2008 financial crisis and the obviousness of fiscal dominance, the repeat in 2020. But especially sanctions, right? Sanctioning if you have a trillion dollars of treasuries as your savings, your national savings and there's any sanctions risk that's somewhat unacceptable, right? Ken Rogoff called it a default. Right. The sanctioning of central of reserves held by the Central bank of Russia at
- [16:04]
D
a very high basic level. You could generalize, you can drill down what is more risky. All else equal emerging market government bonds or corporate bonds. Historically, and I know that varies by everything, but what's your take on that question?
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C
Yeah, I would say the following. I would change the comparison a little. I would say if you have. First of all, everyone is up to their necks in corporate bonds. I don't care whether they're EM or dm. I dare you to find anyone who's not up I G U s up to my neck. High yield US up to my neck. So let's focus on that. Number one, if you own High yield or US cor high yield corporate or US Corporate, you're going to get paid more for the same rating. And just because it's called EM and it's going to be harder to get that rating. Moreover, illiquidity in corporates is the big risk. And I'd argue that the illiquidity of US high yield is a little lower than the liquidity in EM because I can trade with Goldman, Morgan Stanley, bank of America and Standard Chartered, but I can also trade with local Mexicans, local Brazilians. We've got additional counterpart. I grew up on a high yield desk, so that's the straight apples to apples comparison. EM US or DiEM US for high yield IG now on local on their bonds and their own currencies, let's say the government bonds, that's the real yield. And I'll just say two general things other than that EM has outperformed Treasuries. And those two things are number one, all my countries have high real interest rates. The central bank is only focused on inflation. And in Asia most of these countries have lower inflation than the United States. And so this has been an effective stabilization and their currencies have stabilized as a result. And we've seen this pop up for several years now with headlines on UK and Japan. And we've seen two Eurozone crises. What I tell a lot of investors is this is institutions normally have 3%, pensions normally have 3%. I tell folks to imagine two scenarios. One is their Portuguese advisor during the two Eurozone crises. So you're a Portuguese advisor, you got a billion dollars in assets, you're talking to your clients during one of the crises. What are you telling them? You're telling them you have to be long Portuguese treasuries, the capital charges are non existent or low, the regulator favors them, it's an uncertain time, they're going to rally. And what happened? It got downgraded to below Nigeria. You were not helped. Right? So that's one framing. The other framing is put yourself as just a neutral, educated observer in Singapore. You're watching the U.S. you're not saying, oh my gosh, I just wish the political team Red or team Blue won, right? You're not saying either one of those things. You're hoping, I hope they figure out some sort of 60, 70% thing and figure out the overall strategy that's continuous, especially if you're a central bank. And so that's the framing I would give. And it's not that any of this stuff is going to happen, it's that you're not getting paid for this stuff, right? We've got lower volume, higher carry and the newspapers just scream about these fiscal and eventually central bank issues which lead to currency issues and financial issues in these countries, which would be fine if you're getting paid for it. The last thing I'll say is if you measure fundamental risk on an x axis and you say, okay, you, this is a country that everyone can agree has bad fundamentals, this is one with good. And then you draw a line to say how much do countries called developed markets pay you as they get worse in quality and how much the ems as things called developed markets get crappier and crappier, they don't pay you anything more. Japan had 2% yields this year, right? And EMs pay you what you're supposed to get, right? There's a real market for it. They go to the market, they talk to people like me and they say, what do we need to do? Why are we doing so badly that our yields are higher, our spreads are higher?
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D
Why is that?
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C
These are the kids that grew up tough that didn't have a trust fund and had to work hard and now they're in good shape, right? It's as simple as that. When, when I was at Morgan, I ran research at Morgan Sandler, Em, you know, sell side economics, bond strategy. One of the interesting conclusions we found was higher indebted countries are richer. Richer countries can afford more debt, okay? You just need to read literature to know that that goes wrong. Unfortunately, we live in a world of statistics and since you know, this stuff hasn't happened in particular in the US in a long time. It takes an em person to say, well, this happens all the time. I've seen it 80 times. And this is where for the last few decades you've been hearing the alarm bells on the fiscal positions of the US, UK, Japan. It's been people at the IMF or people from EM right who have seen this movie 80 times. It has not been US or UK or Japanese, you know, for decades have been pounding on this. They, they've been saying, it's okay, we just need a rate hike. We just need this reform program. So that's one version of the answer. The other version of the answer is in 2008 we guaranteed all derivatives, right? About a quadrillion notional. That is an incredible amount of forbearance or leverage. That's what's feeding through the system. The US has what we're dependent on the. How many people live in the Cayman Islands, right. They've managed to somehow save like a trillion dollars to lend to us, right? So the central bank, the amount of leverage in the system, hidden or not hidden, we've written a paper on how to measure it is extremely high in these developed markets. Right. The banks were guaranteed. My country's Finance One was the biggest bank in Thailand in 1997. And the authorities decided, and it was good policy, say, yeah, we're not going to take over the bank and guarantee it. And you know what? Thailand is a better credit for it. Right. They don't have the banking system as this massive liability. Whereas.
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A
So you're saying that they don't do a lot of the same bailouts and such.
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C
Correct. Which is good. China had a real estate crisis, right. Did they bail it out? No, they let it happen.
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A
So you keep. Eric, you've said a few times, my countries. Do you have a list of countries that like, you're like, these are the countries that I will invest in or do you have more A list of criteria that you say, once a country reaches these criteria, then I will invest in them.
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C
A list of countries. We have a benchmark. It's ironclad. We can. And if, if our.
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A
How about another way? Is there. Are there any countries you won't invest in? You say, nope, Uninvestable. Not touching them.
- [22:39]
C
Absolutely. Do it all the time. We can't do it too much. We're allowed to exclude 15,1 5% from our benchmark. But absolutely. And right now, you know, we like India as a, as a, as an equity market, but As a fixed income market, as an fx, it's not ready for prime time and so that's something we're very comfortable excluding the current, you know, all these things that I described of good markets, namely central banks that maintain high real rates that have a free floating exchange rate. That's not India. Right. So we don't. I definitely didn't want to give the impression that everything in EM is awesome. There are definitely some problematic countries. India is a big one. Indonesia arguably Philippines and Thailand right now with high energy prices. That's normally why EM bond funds are actively managed. However, given the sort of interesting nature of the kinds of things we talk about, I'll re emphasize that our benchmark has outperformed treasuries in the AG for 10 years. In other words, it's great that we've been able to navigate do better but that should not be the threshold if just passive because I get that a lot of people somehow feel that passive is an easier decision. That's a fine conclusion. That's a far better conclusion than most people have right now. Um, but yeah, what you asked about is a good reason for active especially with bonds as you know, bonds are really about not making mistakes because you get paid so little. Right. And also I'm always sitting in a room next to somebody talking, talking about Nvidia and so they don't want to hear from me.
- [24:09]
D
So, so, so Eric on that I'm curious. AI has been a global trade. Samsung and SK Hynix are of course a huge part of their benchmark and a lot of these companies are issuing a lot of debt. I'm wondering how you're thinking about that. What sort of framework are you using really?
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C
None. The two questions that get asked on AI one of them I have a table pounding no opinion like is this thing going to work? I think there's way too many opinions on that. You don't need another on is this a good thing or not? I have no idea. That's additive. The other one is what the capex cycle. The capex cycle is taking on strategic dimensions. Right. So it's going to continue whether the thing works or not and that should crowd out the consumer. I think that's the only economic conclusion you could come to and it should eventually be adverse for the US economy, probably positive for yields. Sorry, that's not a sexy answer. That's a very economics answer but I think that's the way of looking and the debt is being, you know look, I, I don't want to mention specific names but only one of the big names is not, you know, an unassailable balance sheet. So it doesn't strike me as one of those kinds of problems. But I say that only based on experience in debt markets over 30 years, not those specific types of situations. But the capex is real and it's going to continue whether it's, whether it should or not.
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A
When the, when the war in Iran started, a lot of people said a lot of these emerging markets are screwed, right? They, they are heavily reliant on that for oil. And the US is energy independent. The US is gonna be fine. But these emerging markets, especially Asian countries, are out of luck. Emerging market stock markets have been fine. How are things in the bond, how have things in the bond market done since the geopolitical situation hit?
- [26:01]
C
That's a great point, Ben. And this was the same last year. I'll just expand, I'll riff off and magnify. Last year, what was, what were all the cool kids saying in response to Liberation Day? Oh my gosh, Asia's going to get destroyed. And moreover, China has to devalue its currency because like when I was a sell side economist on these countries, they're solving for the manufacturing export surplus, but they've been running these for 30 years. They're up to their necks in dollars. And so what happened last year, everyone thought CNY should go weaker. Misunderstanding of the situation. The tariffs were essentially a message your currency needs to strengthen. And what's the position of these currencies? Up to their necks in dollars. So they're told those dollars are going to go down against their currency. What do they do? They did exactly what they did last year, which is sell the heck out of dollars. Right? That was the story of last year. And the dollarization thing became a hot story again this year. Iran happened. Oh no, hey, Ben, let's not start with Iran. Let's start with Venezuela. Ships sail in Venezuelan, we accumulate Venezuelan bonds. Americans are conditioned to think, oh, there's an adverse geopolitical headline. I'm supposed to sell my risk. I don't get that. It's good for Venezuela. You know who else won? Latin America? Colombia. Colombia is one of the best performing local currency markets. We may not view it this way. And I'm not saying this is an endorsement of policy from anything other than is it good or bad for my bonds. I'm not getting into whether it's good or bad in principle and all that stuff. It is good to have the US as a stabilizing influence in a lot of These countries both security and for financing wise. In fact, this has been going on for a couple years in our portfolio already. Ecuador, right, had a very positive election, IMF agreement, US tried to reopen a base with the friendly government there. Didn't succeed and yet it's still working. Bolivia just had an election, met both president. The two market friendly candidates, one hour, one on ones. They did it with a lot of people in the market. Clear support from the US treasury to smooth the transition because they're doing some hard things during the transition. And then Iran oil prices go higher. Sub Saharan Africa is replacing Russia and now big parts of the Gulf as a supplier of commodities to the rest of the world, Latam is a supplier of commodities. That's really far from the region. And unless you think whatever happens with the Iran war, whatever you want to call what's going on negotiations, it's not a stretch to say that there's reasonable odds of a scenario where risks remain elevated, right. And these prices remain high. And so we for our portfolios or typical portfolios for your audience are going to think, oh my gosh, this is high inflation. It's bad for growth because now we're paying $5 a gallon for gas and we're going to consume less and we might have a recession. Whereas a lot of my countries, this is boom time.
- [28:50]
D
Eric, last question for me. What do you make of the global rise in yields?
- [28:58]
C
I think it was primarily driven by the US that's how I felt it. I'm sitting here staring at screens. I used to trade, I don't trade directly myself now. And the way it felt, which I think is really important we do our own trading, is this was led entirely by US rates and if that's not true by UK and Japan. That's what the story has been. Even the Wall Street Journal reports about it. Fiscal dominance, debt deficits. Liz Truss know who? Who knows who Liz Truss is? Other than that, you know, moment. That's number one. Number two, as interest rates rose, of course my bonds, interest rates rose along with them, but the currencies didn't weaken, my currencies did not weaken. And so my market was essentially saying, okay, you're the king of rates. You're, you set a somewhat of a benchmark and if they go up, we'll let our rates go up. But number of central banks got more hawkish afterwards, so their currencies were stable, which the market was saying, okay, rates have to go up. But then the central banks reacted as they have for over 10 years. Performance proof wise but 20 plus years of actually doing it, that sends a signal to the market that okay, you know what, these higher rates are a gift from the US because their inflation rates in a lot of these countries are not significantly higher, particularly if they have good policy to address them. If their currencies are appreciating, which is the case in a lot of them, what do you think's happening to their inflation? It's going down. So that's the thing. Their inflation may be going up at the central bank hikes rates and their currency's rallying because they're exporting their export prices more than their import prices are going up, their export prices are going up and so their currency's rallying, inflation's and expectations are going down. And so it was a short term knee jerk. The currencies didn't adjust and it created probably a really really great entry point for yields globally.
- [30:51]
A
Eric, if people want to learn more, where do we send them?
- [30:54]
C
Vaneck.com My name's Eric Fine. Our fund is EMBX and really appreciated this meeting Michael and Ben us too.
- [31:04]
D
Thank you.
- [31:07]
A
Thanks to Eric. Remember check out vaneck.com to learn more about the van ack you merging market spondy TF that we talked about today and then email us animalspirits at the compoundnews. Com.