Article / 06 September 2017 at 10:00 GMT

Weekly Bond Update: BRICS revisited — #SaxoStrats

Head of Fixed Income / Saxo Bank
Denmark
  • The 2008-09 global financial crisis hit the BRICS nations hard
  • The crisis exposed the vulnerability of the BRICS
  • The experience of Brazil and Russia shows that BRICS bonds can be risky
  • It's incorrect to believe low commodity prices always hurt these five nations

By Simon Fasdal

The BRIC acronym (without the "S") was originally coined by Goldman Sachs Asset Management in 2001 as a way of classifying several major emerging economies: Brazil, Russia, India, and China (the "S" for South Africa was added later). 

When first introduced as investment objectives, these markets quickly became extremely popular among investors as growth prospects and return potentials looked strong. They also delivered nice returns... at least to begin with.

BRICS growth rollercoaster:

Growth Rollercoaster

Source: Saxo Bank 

The 2008-09 global financial crisis hit the BRICS hard. The following deleveraging of the global financial system that followed brought difficulties for emerging market economies and resulted in lower growth and investors avoiding the BRICS in both stocks and bonds.

Growth quickly returned, but the vulnerability was exposed and some of the magic was gone; The BRICS nations were now viewed more critically than before. Political risk factors as well as risks concerning the potential immaturity of financial systems were addressed, and this eventually placed liquidity in jeopardy. 

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While it is true that Russia depends on oil and gas revenues, there is a misconception that low commodity prices always hurt the BRICS economies. Photo: Shutterstock


Political and geopolitical risk triggers have affected both Brazil and Russia, and within the last four-year cycles have seen fallouts of quite astonishing proportions. Brazil entered a bearish asset ride on the back of low commodity prices, very low growth, political failure, and scandals.

Russian asset prices melted after the rouble weakened significantly in January 2016 following a sharp drop in oil prices and geopolitical related sanctions.

But after sharp drops in asset prices, especially USD-denominated bonds, both countries showed resilience (in corporate and government bonds). This sudden rebound to a strong position has endured; as of today, BRICS bonds as a whole have seen relatively robust performance.

The same goes for the entire EM bond asset class, which recently entered record territory.

Up, up, and away for EM assets:

Up up and away for EM assets

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Source: Saxo Bank 

So while we are aware that these bonds can be risky, we also know that they can bring in abundant returns if the right conditions occur.

As bond investors it would be in our interest to know the behaviour of these bonds and what the major triggers are. Fortunately, the last decade has revealed some rules of thumb. 

To boil it down, the following are some of the major factors that influence price behavior on EM bonds:

  • Commodity prices: There is a misconception among investors that lower commodity prices are always destructive for EM and BRICS nations. That is not entirely correct. Agreed, the Russian budget is dependent on high oil and gas revenues, and Brazil has a hard time if iron ore prices fall too sharply. On the other hand, China and India could see significant benefits from lower commodity prices.
  • Fed hikes: This may be the single most significant factor for future returns. We saw a major selloff in EM assets after former Federal Reserve chair Ben Bernanke dropped his tapering comment in 2013. Since then, announcements of monetary policy tightening, including actual rate hikes, have sent initial shockwaves into EM assets. The latest such instance was in November 2016, after the Fed mentioned tighter policy, which was followed by the December hike. Future policy tightening by the Fed, the European Central Bank, and the Bank of Japan will be public enemy no. 1 for BRIC bond performance and we will certainly see at least an initial impact.
  • Geopolitics: Again, I believe the perception is that a Russian standoff, or a crisis in the Middle East, will significantly impact EM and BRICS bonds. The history of the last five years has shown that this is not the case. There has been an initial brief impact in most cases, but with very little follow-through on the price action.
  • US dollar: EM bonds like a modest weakness in the USD, as this brings in several benefits. EM countries' USD-denominated debt becomes more manageable. Stable or stronger EM FX have shown to attract investors into carry trades, which again impacts assets denominated in local currency in a positive manner, with spillover to EM assets denominated in hard currency. The only disadvantage is if the EM FX becomes too strong, and the dollar too weak – then EM lose their competitive power against USD. On the other hand, a very strong dollar igniting serial selloffs in EM FX and EM assets does have a much higher fear factor.
  • Low-yield environment and low global inflation: This is probably the biggest trigger for the present goldilocks scenario, which has been the catalyst for major outperformance in BRICS and other EM bonds. Low-for-longer yields in most core bond markets – the US, Europe, and Japan – have worked as a hard gravitational force on pockets of yields in other markets, pushing down those yields in a yearlong process as investors evaluate risk/reward and reallocate funds into these assets (with the 2017 rally as the most dominant example of such).
BRICS bonds are here to stay, and are growing in size and popularity. There are concerns, however, that relate to the aforementioned potential risk factors, and adding to these, an underlying fear of low liquidity at a potential mass exit point (i.e., a selloff).

It make sense, however, for investors to diversify larger portfolios with allocations of EM and BRICS bonds. One major advantage is that they have a different correlation pattern than many other asset classes, which takes away the one-sided risk that many single-country equity investors face today. 

Another big plus is the fact that  BRICS (and other EMs) have emerged to such a degree that they are now "matured EM", with much more developed political and financial infrastructures than, for example, frontier markets.

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Leaders from the BRICS met in Xiamen, China (above), from September 3-5; Russia's Vladmir Putin also met China's Xi Jinping in a side meeting at the summit. Photo: Shutterstock

 — Edited by Robert Ryan and Michael McKenna

Simon Fasdal is head of fixed income strategy at Saxo Bank.

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