OPPORTUNITY IN EMERGING MARKET DEBT
EMERGING-MARKET debt (EMD) has rallied sharply this year, bouncing back from a tough 2018. Is now a good time to add exposure? We would be buyers on any material selloffs, because we see fundamentals remaining supportive in coming quarters. Our overall view on emerging markets favours equities over debt, yet we believe EMD offers an attractive income for bond portfolios.
This year’s EMD rally is evident in how both local-currency and hard-currency EMD yields have fallen significantly as bond prices have risen. Yield spreads between EMD and US investment grade bonds have tightened as a result. But EMD yields remain attractive on an absolute and relative basis over the longer term. Yield spreads between hard-currency EMD and investmentgrade US bonds hit highs last year not seen since 2016. Spreads remain wide in the context of the past few years, even with EMD’s recent outperformance over investment grade and high yield. A reason EMD valuations still appear reasonable: the asset class took a hit last year as the US Federal Reserve raised interest rates and the dollar appreciated. The backdrop for the asset class this year appears very different.
We see three major drivers of this year’s EMD rally, all likely to persist into the second quarter. Most importantly, the policy backdrop has quickly turned more supportive. A US-led slowdown in global growth as the economy enters a late-cycle phase has prompted major central banks to slow their planned pace of normalisation. The Fed’s swift pivot from tightening to a policy pause has helped to spur demand for EMD, as has the subsequent waning of dollar strength. A pause in the Fed’s hiking cycle eases the burden on emerging markets with high external debt loads. A softer or stable dollar supports emerging-market currencies and underpins local-currency debt returns.
The second driver, the most under-appreciated, is large demand meeting tightening supply. EMD experienced sharp inflows along with other fixed-income risk assets early in 2019. At the same time, market volatility led many emerging-market issuers to postpone offering new debt: January issuance was below year-earlier record levels. We expect the new-issue market will take time to restart in earnest. Until then, limited new supply should underpin the market. Another driver: our indicator shows market attention to geopolitical risk has subsided modestly since last year on easing concerns around a significant nearterm escalation in US-China trade tensions.
The growth story in emerging markets is also generally improving following weakness last year. We see policy easing underpinning a modest growth re-acceleration in China during the first half this year.
The risks: an escalating US-China trade conflict, a return of recession fears or an inflation resurgence sparking earlier-than-expected
Fed tightening. US-China trade negotiations look to be progressing, though frictions related to competition for global technology leadership are likely to persist.
We have become less concerned about dollar strength and see the Fed on hold until at least the second half. The bottom line: we would look to increase EMD exposure on any price setbacks in the first half, and maintain a neutral view overall.