Actively Navigating Iran-Driven Risks in EM Debt

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The bulk of the relevant asset prices directly affected by Iran are in the Gulf; that’s what matters and has superior analyzability. Gulf bonds were largely unchanged, yet the risks to the region have clearly risen. What is our portfolio view? We went home on February 27 with underweights in the Gulf (Saudi, UAE, Qatar, Kuwait, in particular), because an event was obviously on the way and we wanted room to accumulate, assuming asset prices cheapened and the likely outcome was benign. On Monday, March 2, when markets opened, we were struck that these asset prices didn’t move. Risks certainly seemed higher to us – on Friday we went home with the market having a base-case of a <1 week conflict and now we have a conflict set for what looks like a minimum of many weeks. Risks higher, prices unchanged, you sell, which we did, and continued Tuesday, March 3. Iran matters mostly to the Gulf (as opposed to other EM regions) and represents to us a reason to be underweight at least in the region.

We see two scenarios, fairly balanced in probabilities – either Iran will be able to project meaningful force in the Gulf, or it will not. A “noisy” but toothless Iran is not the same as an Iran unable to materially affect the Gulf. If Iran is incapable of generating risk to the region, the discount of the region should decline. And, the region is the most analyzable in terms of Iran (due to obvious proximity/materiality) and has the bulk of the assets. The problem with a bullish scenario is that those assets didn’t get cheaper as we noted above. And, despite a “regime change” objective on the part of US/Israel, the regime has not changed and has an explicit strategy of surviving “60-90 days”. That’s pretty specific and fits the game-theory – “I see your four weeks and raise you to 3 months”. Risks must remain high to our eye and 50/50 seems the least bad odds.

EM has many potential winners in both scenarios. Commodities exporters in Latam and Sub-Saharan Africa are serious potential winners in both scenarios. The Gulf is a potential winner only in one scenario. Our primary concern is whether we’ll even get a buying opportunity. We noted that Gulf assets were remarkably stable in the face of proximate risks. Well, EM assets generally weakened…but not that much. And, we were not explicitly waiting for them to cheapen as we were with the Gulf. Latam and SSA were already replacing Russia as Europe’s commodities supplier. In a scenario in which Iran remains a material risk to the region, but is in a prolonged conflict, Latam and SSA are winners, in our view. The only issue is how much of a generic “risk-off” moment we get in this Iran situation (i.e., all risk assets correlated).

Exposure Types and Significant Changes

The changes to our top positions are summarized below. Our largest positions in February were South Africa, Mexico, Poland, Thailand and China:

• We increased our hard currency sovereign exposure in Saudi Arabia. This reflected our views on global duration, which was expected to benefit from the removal of the IEEPA tariffs, as well as a slower growth in the U.S. In terms of our investment process, this improved the technical test score for the country.
• We also increased our local currency exposure in China, Thailand, and the Philippines. China continues to guide the currency stronger in an effort to boost domestic consumption and lower trade surpluses. China also continues to support domestic demand, albeit at a modest pace. In terms of our investment process, this improved the economic and policy test scores for the country. The Philippine local bonds are among the least correlated with EM peers, longer-dated bonds have decent valuations, and there is potential for more policy rate cuts. These factors strengthen policy and technical test scores for the Philippines. Thailand’s exposure in question is local duration, which continues to benefit from very low inflation, while the currency has the high correlation with the Chinese renminbi. These factors improved technical and economic test scores for the country.
• We reduced our local currency exposure in Mexico and Indonesia. Indonesia’s policy mix continues to deteriorate, as the pro-growth agenda seems to the top priority both for the government and for the central bank, weighing on Indonesia’s policy test score. In Mexico, we were concerned by a combination of stretched long positioning and a spike of cartel-related violence, which worsened the technical and policy test scores for the country.
• We also reduced our local currency exposure in Chile and Brazil. Chile’s local bond valuations are not attractive (the lowest valuation bucket), while softer global activity is a headwind for copper prices. These factors worsened Chile’s technical test score. Brazil’s local bonds and FX positioning became very elevated after a massive year-to-date rally, worsening the technical test score for the country.