GMO Emerging Debt Insights

Jan 2019
Crisis and Opportunity in Emerging
Market Debt
Carl Ross

Executive Summary
Emerging market sovereign debt in U.S. dollars can offer strong returns for investors who can ride out
periodic bouts of volatility caused by concurrent crises in one or more countries. Crises, though real and
frequent, are not typically as destructive to a country’s fundamentals as observers imagine. When crises
drive valuations to over-discount changes to long-term country fundamentals, it can be an attractive time
to buy emerging sovereign debt. We believe today, following the recent 100-bps widening in sovereign
spreads, is one of those times. Further, we believe that our low-turnover, value-oriented strategy can
generate alpha above the base case.

Introduction
Crises happen, especially in the emerging world. Commodity swings, political upheaval, less developed
institutions, economies levered to global growth – it seems something is always “going wrong” in one
or more of the 85+ countries in the investable emerging debt universe. When we assess the severity and
impact of the crises, we often see opportunity.
Definitions of what constitutes a ‘crisis’ vary. Emerging debt practitioners count the “biggies” as the
Tequila crisis of 1994, the Asia/Russia/Long Term Capital crisis of 1997-1998, and the Lehman crisis
of 2008. In each of these crises, spreads widened by hundreds of basis points, resulting in substantial,
temporary declines. As the asset class has matured and the investor base broadened, such massive spread
widenings have become more rare.
For this piece, we define a ‘crisis’ broadly: a widening of the benchmark credit spread by at least 100 basis
points over a seven-month period. As seen the chart below, crises defined in this way are frequent (11 in
the past 20 years), and their causes are somewhat random and difficult to predict. They can be caused by
events that are exogenous to EM, such as the bursting of the technology bubble in 2000 or the European
Sovereign Debt issues of 2011-2012, or by endogenous events like the Asian crisis of 1997-1998 or the
2014 oil price collapse and Russian military intervention in Ukraine.

1
 Exhibit 1: A History of Rapid Selloffs in Emerging Debt
1600
Asia
Oil

7-Month Change in EMBIG Spread (bps)

Crisis
1200 Ukraine
Venezuela
Argentina
800 GFC
Tech Argentina
Bubble & Brazil European China
400 Fear Sovereign Debt Brazil
of Fed
0
Today
-400
Beginning of Taper
housing jitters tantrum
-800
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Exogenous to EM Endogenous to EM

Source: GMO, based on JP Morgan index data

Note: Defined this way so as to include 2018 as a crisis year.

The good news, though, is that these crises, though frequent and hard to predict, tend to produce fast
recoveries. Total return drawdowns are typically shallow (less than 10%), partially due to the dampening
effect of U.S. interest-rate exposure, with full recoveries often taking no longer than six months, according
to our calculations.

Exhibit 2: With Few Exceptions, Drawdown Recoveries Have Been Relatively Fast
40% 500
35% 450
400
Decline in EMBIG Index

30%

# of Calendar Days
350
25% 300
20% 250
15% 200
150
10%
100
5% 50
0% 0
Dec'97 to Mar'99

Dec'14 to Mar'15
Aug'13 to Aug'13
Nov'00 to Dec'01

Sep'08 to Apr'09
Nov'07 to Feb'08

Jan'16 to Feb'16
Sep'11 to Feb'12

Sep'18 to Sep'18
May'04 to May'04
Jul'02 to Dec'02

Index Decline Days to Recovery

Source: GMO, JP Morgan

2 Crisis and Opportunity in

Emerging Market Debt
Jan 2019
 Permanent impairments of capital are also rare, and in EM debt are limited to losses from default. Borrower
Turkey’s Roller Coaster Summer of 2018
countries seek to avoid causing such losses, as they want to protect their access to the global credit markets.
While these losses can be large in certain very unique circumstances (one being Argentina’s default of
2001), they are generally quite small and surprisingly infrequent.

2018 Example: Turkey

Turkey emerged as a buying opportunity in the second half of 2018 as spreads widened significantly, and
the lira declined sharply. The lira’s decline sparked high inflation and rising loan defaults among Turkey’s
domestic corporate borrowers. Despite these short-term impacts, the country continued to score highly on
our quantitative screen, as shown in Exhibit 3.

Exhibit 3: Turkey’s Roller Coaster 2H18

1000
900
800
10‐year bond spread (bps)

Turkey
700
(Stress Scenario)
Turkey (Aug)
600 Iraq
500
Turkey (Jul) Pakistan
400
Senegal
300
El Salvador
200
100
0
0 20 40 60 80 100
GMO Country Risk Score
As of September 2018
Source: GMO Emerging Debt
Note: GMO’s Proprietary Credit Score incorporates measures of fundamental credit quality
The securities identified above represent a selection of securities identified by GMO and are for informational
r 2018 purposes only. These specific securities were selected for presentation by GMO based on their underlying
merging Debt characteristics and not their investment performance. The securities above are not necessarily representative
oprietary Credit Score incorporates measures of fundamental credit quality
of the securities purchased, sold, or recommended for advisory clients, and it should not be assumed that the
entified above represent a selection of securities identified by GMO and are for informational purposes only. These specific securities were selected for presentation by GMO based on the
investment in the securities identified will be profitable.
acteristics and not their investment performance. The securities above are not necessarily representative of the securities purchased, sold, or recommended for advisory clients, and it 
sumed that the investment in the securities identified will be profitable. . 
We believed that because Turkey had a comparably sound economic structure and fiscal sustainability
ation – not for distribution. For Institutional Use Only. Copyright © 2018 by GMO LLC.  All rights reserved. 
to its peers, bolstered by external liquidity that would likely improve as a result of lira devaluation and
economic policy responses, that spreads of Turkey’s debt had widened beyond what could be justified by
fundamentals and therefore represented a buying opportunity. We wrote about the opportunity afforded
in Turkey and Argentina in August.1

The Opening Value Opportunity

As a value-based investor, we take great care to compare market prices to fundamentals when advising
potential investors about their allocation decisions. Below you will see our preferred metric for evaluating
emerging external debt, the “credit loss multiple,” as of 10/31/18.2 The 3.3 current level is just above the
level where credit returns to external debt investors have been skewed to the positive over time. After
a few years of seeing this multiple languish either in the “neutral” (between green and red) or, worse,
1
Thoughts on Turkey And Argentina Across EMD Portfolios (August 2018), available at www.gmo.com
2
Available for subscription at www.gmo.com.

3 Crisis and Opportunity in

Emerging Market Debt
Jan 2019
“overvalued” (red or below) zone, we’re happy that the recent ‘crisis’ has opened this valuation opportunity
for prospective investors (green and above).

Exhibit 4: Long-Term View of the “Fair Market Multiple” for Emerging External Debt
16

GMO EMBIG Credit Loss Multiple

14

12

10

4
3.3
2
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

As of 10/31/18
Source: GMO, Haver, J.P. Morgan. Note: The methodology to the EMGO GBI-EMGD Expected Spot Return and
GMO EMBIG Credit Loss Multiple can be found in our Quarterly Valuation Update publication.

Alpha Prospects
In addition to the improvement in the asset class valuation, we are fairly sanguine about alpha opportunities
prospectively for our portfolios, both in security selection and country selection.
Turkey and Argentina, for example, both represent country overweights, and, within the two countries,
each has attractive sovereign and quasi-sovereign security selection opportunities.

Conclusion
After a turbulent second half of the year and a widening of spreads, we believe emerging debt offers
attractive valuations and opportunities for alpha. As GMO enters its 25th year managing emerging debt,
we have become used to periodic crises, both big and small, and we believe we are well positioned to take
advantage of them.

Carl Ross. Dr. Ross is engaged in research for GMO’s Emerging Country Debt team. Prior to joining GMO in 2014, he was a managing
director at Oppenheimer & Co. Inc. where he covered emerging debt markets. Previously, he was the Senior Managing Director and Head
of Emerging Markets Fixed Income Research at Bear Stearns & Co. Dr. Ross earned his BA in Economics from Mount Allison University as
well as his M.A. and PhD in Economics from Georgetown University.

Disclaimer: The views expressed are the views of Carl Ross through the period ending January 2019, and are subject to change at any
time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be
construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should
not be interpreted as, recommendations to purchase or sell such securities. Forward‐looking statements based upon the reasonable
beliefs of the Emerging Debt team and are not a guarantee of future performance. Forward‐looking statements speak only as of the
date they are made, and GMO assumes no duty to and does not undertake to update forward‐looking statements. Forward‐looking
statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially
from those anticipated.

Copyright © 2019 by GMO LLC. All rights reserved.

4 Crisis and Opportunity in

Emerging Market Debt
Jan 2019