Like the rest of fixed income, emerging market debt (EMD) enjoyed the global bond rally as central banks consistently eased monetary policy in 2019. In addition, the spread between Treasuries and the benchmark EMD dollar index fell from 400 basis points1 (4.00%) to about 340 basis points (3.40%) as the Federal Reserve (Fed) switched gears to easing. The combination led to double digit year-to-date returns across dollar-denominated and local-currency-denominated EMD indices.
How do valuations look after strong year-to-date performance?
Despite strong year-to-date performance, overall valuations are fair but not expensive. Current spreads2 represent a mid-point between the start of the Fed’s indication that rate hikes were over, and the near-term historical lows of February 2018. With very low yields available across most mainstream developed fixed-income markets, emerging market (EM) dollar index yields of slightly more than 5% remain attractive.
To achieve a price gain on top of the available income, it will likely require the US dollar to fall from currently elevated levels. In spite of Fed rate cuts, the dollar has appreciated about 3% in 2019. Any relative weakening of US growth prospects compared to the rest of the developed world, that contributes to a weaker dollar, would likely be very beneficial to the EMD return outlook.
Why the fundamental outlook remains broadly supportive
While economic growth is sluggish globally, overall EM growth is still about twice as high as the developed world. Regionally, Latin American growth is the most troublesome, with close to zero growth in Brazil and Mexico and a recession in Argentina. European EM growth is steady at just over 2% in most places, while EM Asia growth remains relatively robust, despite slowing in China and India. Catalysts for upside surprises appear scarce, unless developed countries embark on more determined fiscal stimulus.
The good news, however, are the low and stable inflation rates across a broad swath of the asset class. These have allowed for interest-rate cutting cycles that have boosted local returns, and more rate cuts are likely in Russia, Mexico, South Africa, and Brazil. Stable inflation has also fed into less volatile currencies. That has made the large yield advantage in local debt more attractive for investors on a risk-adjusted basis.
To us, this seems like a structural change that will over time reduce funding costs in local currency and should lead to more stable and predictable rate cycles that improve investor confidence.
Perhaps the biggest risk does not stem from broad macroeconomic factors, but individual country hotspots. We expect Argentina to embark on a debt re-profiling. Lebanon, as we write, is trading at distressed levels with significant governance questions, and Ecuador is struggling to pass fiscal reforms despite a market friendly executive.
As these trouble spots have arisen, contagion into neighboring countries or more broadly into EM has not occurred. This suggests that the market has differentiated these risks and favors those countries best able to take advantage of the positive macroeconomic tailwinds.
Where are the opportunities in 2020?
We see value across a number of diversified themes next year:
Those EM countries where the macroeconomic outlook is improving are amply rewarded by investors. Brazil’s progress on pension reform, with a roster of other potential reforms to follow, has led to more than 14% returns on dollar bonds. Russia’s large current account surplus and sound policy mix has given investors a return of more than 18%.
Although outsized gains might be harder to come by, incremental improvements in governance in places such as Turkey and Mexico, where expectations are low, offer potential for gains. In lower-rated sovereign credits, those with stable International Monetary Fund-approved frameworks such as Ukraine have outperformed. Going forward, there is likely to be less dispersion in returns and a diversified sovereign exposure across rating categories is likely to be the best way to access this part of the opportunity set.
Within corporate debt, companies within those improving countries offer great opportunities to pick up yield over sometimes stretched sovereign valuations. One seemingly structural improvement to note is the increasing ability of corporate issuers to access markets to refinance debt maturities in the current low-rate environment. This is likely to improve credit profiles and reduce downside risks.
In local currency, those countries with higher real interest rates seem best poised to continue to outperform. Indonesia, Russia, and Mexico offer investors higher rates with a greater potential for price appreciation as other local opportunities fade. If the dollar does turn down, the central European complex that trades with a high correlation3 to the euro are likely to do very well. High grade Asia offers currencies that have very low volatility that could also outperform in a falling-dollar environment.
1 A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
2 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
3 Correlation is a statistical measure of how two investments move in relation to each other. A high correlation occurs when two investments generally move in the same direction.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets.
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