A better year ahead for emerging markets debt?

We believe a better year is ahead

2018 was only the third year in the past 20 where the asset class produced a negative return; the other loss-making years being the year of the Global Financial Crisis (2008) and the ‘taper tantrum’ (2013) when Chairman Bernanke announced the reduction of asset purchases by the US Federal Reserve.

The past year has been an unusual one for EM debt performance. US Treasury yields are mostly negatively correlated with EM spreads, so in most periods, losses from rising Treasury yields are compensated by lower EM risk premia. In 2018, however, the US fiscal stimulus led to sharply higher US policy rates, US growth surprises and a strong US dollar. The US dollar strengthened not just against EM currencies, but also against the euro, as growth disappointed in the Eurozone and EM. Other than the strong US dollar and higher US rates, which created a negative environment for capital flows into EM, rising uncertainty about global trade also affected EM countries negatively, as did higher market volatility.

We do not think these headwinds will persist and therefore have a more positive outlook for the asset class. Hard-currency EM debt is expected to perform better in 2019, partly because valuations adjusted so significantly in 2018 and now appear to offer value for long-term investors.

Global environment

Our strongest conviction for 2019 is that asset price volatility will likely remain high, for various reasons. The global expansion is moving towards the end of the cycle and the quantitative tightening of G3 central banks is accelerating as the European Central Bank is set to end its asset purchases. Meanwhile, geopolitical noise is likely to remain high and fuel volatility. The unpredictable nature of US economic policy is itself a major source of volatility for EM.

Amid higher volatility, we nonetheless expect the global environment to turn more positive for EM debt in 2019. The large moves we saw in US short rates in 2018 are unlikely to be repeated in 2019 as the Federal Reserve slows the pace of policy tightening; rates are widely perceived to be approaching the ‘neutral’ rate. As for global and Chinese growth, while we expect a slower pace of expansion in the near term, no recession is in sight. Overall global growth remains robust. Among Ems, we expect to see a recovery of growth in selected countries over the next two years, particularly in Latin America and would expect EM growth to pick up relative to developed markets (DM) as US growth falls closer to potential.

Regarding global trade, we believe that a fairly bearish scenario has been priced into markets, but with the recent de-escalation of trade tensions between the US and China we would expect to see sentiment improve. Nonetheless, US-China economic tensions appear unlikely to disappear, remaining a potential source of geopolitical risk.

EM fundamentals – balance sheets, policy and politics

It is increasingly difficult to discuss EM countries as a group, given the large and growing diversity of EM countries that have issued US dollar-denominated debt. Collectively, however, debt levels in EM countries are still relatively low at 51% of GDP and are bolstered by strong reserve positions.

Figure 1: Government Gross Debt, 2009-2023 (% of GDP)

Source: IMF Fiscal Monitor, October 2018

Furthermore, many of the EM countries most vulnerable to higher US rates and tighter global liquidity have entered IMF programs (Argentina agreed the largest ever IMF program in September) where reforms are a condition of IMF disbursements.

We expect the future economic and asset price performance among EM countries to be varied; thus careful and forward-looking country analysis will be rewarded in a market with such performance dispersion. We currently prefer quality investment grade credits such as Bermuda, Kazakhstan and Qatar. We are more cautious towards countries including Mexico, where we could see a deterioration of policy under the new president. We are selective in higher-yield credits, favouring short-dated bonds with lower volatility. High-yield credits where we see stable to improving fundamentals that are not yet fully priced in include the Dominican Republic, Paraguay, Serbia, Croatia and Azerbaijan.

Politics and policy at the country level – particularly fiscal policy – are likely to be the main performance differentiators between issuers. These drivers could be most in focus in Brazil (pension reform), Mexico (re-orienting government spending) and in some smaller countries, such as Costa Rica, Ecuador and Ghana. In Turkey, we expect monetary policy to remain in the spotlight as the economy experiences a hard landing.

Regarding politics, Argentina, South Africa, Ukraine, Nigeria and Indonesia among others are expected to hold elections. While a Jokowi win is likely in Indonesia, election outcomes in Argentina and Ukraine are less certain. If President Macri can recover some of his popularity, Argentine assets could perform strongly, as the market would price in a continuation of policy normalisation and the prospect of capital inflows.

EM valuations

EM debt started 2018 with a yield to maturity (JPMorgan EMBI Global Div.) of 5.3% and a risk premium of 285bps. Towards the end of 2018, the yield to maturity is now closer to 7% and the risk premium (spread) has risen above 390bps. The asset class has therefore re-priced substantially and entry levels look a lot more compelling than at the start of the year when valuations appeared stretched. We believe total returns from EM hard-currency in 2019 will be positive, as a substantial rise in the overall EM yield would be necessary to erode the carry provided by the now much higher running yield.

Figure 2: Substantial re-pricing of EM debt in 2018: EM debt yield (%)
 

Source: Bloomberg as at December 2018

EM debt also looks attractive relative to other fixed income asset classes, particularly US High Yield. Given that EM debt consists almost equally between investment grade and high yield, the risk premium of EM relative to US High Yield appears quite from a historical perspective.

EM technical position

2018 saw more than US$140 billion of EM issuance, after a record issuance of US$182 billion in 2017. We expect much more subdued issuance levels in 2019, as large 2018 issuers like Argentina are not expected to issue debt. Market estimates for gross issuance in 2019 vary between US$110 to US$125 billion. Since EM countries have large repayments and amortisations in 2019, net issuance is anticipated to be much lower than in the last three years. This should create a much more positive technical backdrop for the asset class.

In terms of flows into and out of the asset class, flow data seems to indicate that there were outflows from retail investors in 2018, but that institutional investors remained invested. Given valuations and an improved global backdrop for EM, we would expect that dynamic to continue.