2018 WAS ABOUT US EXCEPTIONALISM
In our previous quarterly outlook “Wind Against Tide”, we argued that a continued slowdown in emerging markets was to be expected, but no systemic crisis was likely. In the fourth quarter of 2018, we have indeed witnessed a notable slowdown in EM countries, but this hasn’t resulted in a more meaningful market correction. Hard-currency sovereigns came under pressure and posted a negative return of -1.26% for the quarter, while EM corporates were more resilient, posting a -0.04% return. However, compared to DM credit, emerging markets held up relatively well. Furthermore, local-currency debt actually returned almost 3% in the fourth quarter, beating most expectations as EMFX, including beaten up currencies such as the Turkish lira, managed to retrace some of the losses from earlier in the year.
2018 as a whole was a US growth story. With central banks trying to reverse their exceptional support, we gradually moved away from a global synchronised growth backdrop. While many economies started to slow, the US emerged as the backbone of global growth. This US exceptionalism, together with tightening financial conditions and idiosyncratic stories in some countries (most notably Turkey and Argentina) put pressure on many of the less balanced emerging economies thanks to higher borrowing costs and stronger dollar. As a result, valuations started to move against investors from April, while developed markets remained largely unaffected. At the end of the year, this gap started to close as late cycle signals caused investors to reprice DM risk assets more in line with emerging markets.
2018 was a difficult year for EM assets in general.
EXHIBIT 1: PERFORMANCE COMPARISON FOR 2018
Source: Bloomberg, J.P. Morgan Asset Management. Indices do not include fees or operating expenses and are not available for actual investment. EM = Emerging Markets. HG = High Grade. HY = High Yield. UST = US Treasury. EM Sov = JP Morgan EMBI Global Diversified. EM Local = JP Morgan GBI EM Global Diversified. EM Corp = JP Morgan CEMBI Broad Diversified. FX = Foreign Exchange. US High Yield = JP Morgan Domestic High Yield. US HG = JP Morgan JULIR ex-EM. Commodities = Bloomberg Commodities Total Return. EM Equities = MSCI- EM. EUR HG = JP Morgan MAGGIE. EUR HY = JP Morgan EURO High Yield.
Past performance is not a reliable indicator of current and future results.
2019: RE-CONVERGENCE AND A STABLE EM-DM GROWTH ALPHA
We re-iterate our view that emerging markets are in a cyclical slowdown, but we expect emerging and developed market growth to re-convergence in 2019. Last year was dominated by US growth outperformance, which together with unexpected weakness in eurozone growth, greatly impacted financial asset prices for most of 2018. However, we expect US growth to slow as the effects of fiscal stimulus wane. Coupled with stagnation in the eurozone, DM growth is forecast at 2.1% in 2019, down from 2.4% in 2018.
At the same time, we expect EM growth to moderately decelerate to 4.3% from 4.6%, mainly due to weaker growth in China and Turkey. Elsewhere in emerging markets, however, we see growth stabilising or even increasing, especially in Brazil. As a result, the growth differential between emerging markets and developed markets (the “EM-DM growth alpha”) should stabilise at 2.2% (Exhibit 2).
EM-DM growth alpha should fall to around 2.3% 2018 before recovering slightly in 2019
EXHIBIT 2: EM VS. DM GDP GROWTH (% YEAR ON YEAR)
Source: Bloomberg, J.P. Morgan Asset Management. As of December 3rd, 2018. Data for Q3 ‘18 includes some estimates, including for Argentina and Turkey in EM. Aggregates are GDP-weighted. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
Any global slowdown tends to put pressure on economies with high inflation and weak balance sheets. It is likely that we will see, similar to 2018, economies with twin deficits or signs of mismanagement going through a challenging period. On a positive note, the re-convergence backdrop should alleviate some of the pressures for EM economies as the Federal Reserve (the Fed) gradually moves away from its tightening bias. Furthermore, inflation is expected to stay at manageable levels in most EM countries because of lower oil prices, stronger EM currencies in the past quarter and tighter EM central bank policies. We forecast average inflation of 5% in 2019, unchanged from 2018, and adjusted for Argentina and Turkey it would likely decrease.
As the global economy enters the later stages of the cycle, investors have to review several key structural changes that will drive asset price performance. Among many variables, we identify three key factors that will determine how emerging markets will perform in the upcoming quarters: 1) China’s economy; 2) US Fed monetary policy decisions; and 3) US dollar performance. There are other risks, such as elections, idiosyncratic events or trade wars, which remain a wildcard. However, the three factors listed above present cyclical challenges, which are largely unavoidable and to which investors have to adapt.
CHINA: RISKS TO THE DOWNSIDE, BUT STIMULUS MEASURES ARE LIKELY
With over 40% contribution to the overall EM growth, China’s continued slowdown is already having a sizeable impact on EM and global growth. While trade tensions with the US appear to have eased somewhat after the G20 meeting, macroeconomic data in China has continued to deteriorate, further raising fears over the ability of the Chinese government to manage the slowdown. The data suggests largely a broad based slowdown – exports, retail sales and manufacturing all have disappointed. Purchasing Managers’ Index (PMI) readings confirm this: December’s NBS manufacturing PMI fell below 50 to 49.4, the lowest reading since March 2016 as domestic and external factors weighed on business sentiment.
Our base case scenario remains that China will continue to gradually slowdown and that we won’t see either a significant escalation of trade tensions or a sudden back off by the US Administration. In this scenario, we anticipate China’s economy to grow at 6% in 2019 (Exhibit 3). Trade wars remain the wildcard. China has made promises to purchase more US goods, while the US administration has softened its tone on tariffs. Nonetheless, we expect trade tensions to persist, although timing and implementation are uncertain. A resolution to the trade disputes in the near-term looks unlikely, especially as China’s authorities continue industrial upgrading efforts despite US demands for China to back down on its “Made in China” industrial policy.
Supply side reforms and the shadow banking clean-up means China’s economy is better able to deal with the downturn.
EXHIBIT 3: CHINESE ECONOMIC SCENARIO ANALYSIS
Source: J.P. Morgan Asset Management. Probability-weighted China Growth 2019 is 5.88%. FAI = Fixed asset investment. Data as of 7 December 2018. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
The old risks also remain in the background-rising augmented debt, high property prices, increasing onshore defaults and the potential for capital outflows. Despite weaker data readings, we have not seen a large response from China’s policymakers yet. China has room to stimulate its economy, but given some of the measures-such as public debt sustainability or FX reserve adequacy-the country’s policymakers will have to be selective.
Loosening monetary conditions too much would also risk giving up some of the progress made tackling the shadow banking system and inefficient state-owned enterprises. Therefore, we anticipate broad-based measures to be used at the monetary (reserve requirement ratio cuts, open market operations, etc), fiscal (infrastructure investment) and micro levels (tax cuts, etc). Policymakers are likely to focus on the eastern provinces, which have been hit the hardest by the trade war and which account for a large part of China’s GDP. However, the government is not going to be able to sufficiently help every province.
The International Monetary Fund (IMF) minimum reserve adequacy, which has already fallen to only 100%, would be further impacted if China eases monetary policy.
EXHIBIT 4: IMF MINIMUM RESERVE ADEQUACY
Source: IMF, People’s Daily, EMED, J.P. Morgan Asset Management. IMF reserve adequacy uses an average of fixed and floating metric criteria. Fixed = Exports (10%) + Broad Money (10%) + ST debt (30%) + Other liabilities (20%). Floating = Exports (5%) + Broad Money (5%) + ST debt (30%) + Other liabilities (15%).
END OF THE CYCLE: TAILWIND FROM A FED PAUSE?
EM countries are undoubtedly facing challenges from policy risks and late cycle dynamics, but these potential headwinds are mitigated by global re-convergence and increasingly attractive valuations for EM bonds and currencies. In 2018, US exceptionalism (strong growth, a tight labour market, solid corporate earnings and rising interest rates) created a challenging backdrop for the rest of the world as both emerging market and the eurozone growth declined.
The result has been US dollar strength and rising core rates, both of which were detrimental for EM economies. Tighter financial conditions have pushed weaker countries, such as Argentina, to again turn to the IMF for help, while Turkey was eventually forced to raise interest rates to 24% to fight off external pressures.
With poor stock market performance, rallying US Treasuries rallying and a weaker growth outlook, the market has repriced its expectation of the number of US rate increases this year. We now expect that the Fed will have to pause after one or two more rate increases. US financial conditions have also tightened rapidly and this should also prevent the Fed from blindly tightening monetary policy further (see Exhibit 5).
US financial conditions tightened in 2018.
EXHIBIT 5: US FINANCIAL CONDITIONS AND EM BOND SPREADS
Source: Bloomberg, J.P. Morgan Asset Management; data as of 28 December 2018. GS US Financial Conditions = Goldman Sachs US Financial Conditions Index. EM Sovereign Spread = JPM EMBI Global Diversified Spread. EM Corporate Spread = JPM CEMBI Broad Diversified Spread. LHS/RHS = Left / Right Hand Scale.
With relatively loose fiscal policy and interest rate differentials no longer widening, the US dollar is expected by many investors to weaken this year. In the last five cycles, the dollar tended to underperform after the last interest rate hike of the cycle (see Exhibit 6). At the same time, EM assets have fared very well, suggesting that we may see a similar favourable pattern playing out for emerging market debt (EMD) this year.
Local rates and EM sovereigns should outperform in the case of a dovish policy surprise.
EXHIBIT 6: EMD RETURNS AFTER END OF FED HIKING CYCLE (% CHANGE)
Source: Bloomberg, J.P. Morgan Asset Management, data as of 7 December 2018. Average returns of five previous cycles: 1994-1995, 1997, 2000, 2006, 2015-2016. *Returns may not be available for all cycles. ELMI = JPM ELMI Plus. EMBIG = JPM EMBI Global Diversified. GBI = JPM GBI-EM Global Diversified. DXY = US Dollar Index.
Past performance is not a reliable indicator of current and future results.
We can, however, deviate from this scenario. The US Fed may still continue to raise interest rates by concentrating more on the tight labour market and inflation. This would spur further credit spread widening and could stall growth rather than slow it. Furthermore, as US Treasuries rallied at the end of 2018, spreads have actually substantially picked up in emerging markets, and even more so in developed markets. This suggests investors are worried that we are reaching the end of the cycle and are adjusting their credit risk premiums to the new slower global growth backdrop. If such negative sentiment persists, we can see a continued underperformance of credit.
Although the end of the Fed cycle is good for emerging markets, it also signals the end of the business cycle-at least in the US. Slowing global and EM growth will have a negative impact on corporate fundamentals, but at varying degrees for different industries and corporates. Furthermore, we expect financial conditions to continue gradually tightening in the near term, leaving EM countries that deviate from prudent policymaking at risk.
Encouragingly, we have seen, on average, appropriate responses from most EM countries to more challenging external conditions. We have flagged already in our previous quarterly outlook releases that EM fundamentals are broadly in a strong position to weather tighter financial conditions and more challenging macro backdrop. The outliers with current account and budget deficits have already significantly repriced. EM corporate fundamentals, although backwards-looking, continue to point to ongoing deleveraging and good earnings growth (see Exhibit 7A and Exhibit 7B).
EM corporate fundamentals are in good shape but the cycle is showing signs of peaking.
EXHIBIT 7A: NET LEVERAGE RATIO
Source: National Statistics, Bloomberg, JPMorgan Securities, J.P. Morgan Asset Management; data as of 7 December 2018. All metrics calculated by J.P. Morgan Asset Management based on a representative sample of EM corporates.
EXHIBIT 7B: EBITDA* GROWTH (% CHANGE, YEAR ON YEAR)
Source: National Statistics, Bloomberg, JPMorgan Securities, J.P. Morgan Asset Management; data as of 7 December 2018. All metrics calculated by J.P. Morgan Asset Management based on a representative sample of EM corporates. *EBITDA = earnings before interest, tax, depreciation and amortisation.
VALUATIONS: NOT A SCREAMING BUY, BUT ATTRACTIVE
At the start of 2018, hard currency sovereign and corporate debt spreads were at multi-year tights. They moved substantially wider through the year on the back of slowing global growth, more challenging external conditions and idiosyncratic stories. Hard-currency sovereign spreads widened 136 basis points (bps) to 415bps, with the yield in US dollar terms nearly reaching 7% by the end of December.
The asset class has never in its history (data is available back to 2002) posted negative returns in the next 12 months after reaching a level above 400bps (see Exhibit 8). EM corporates, an asset class with a shorter duration and slightly higher average quality, have widened a bit less, but still by a substantial amount, reaching the highest yield since the collapse of Lehman Brothers (6.32%) and a spread of 366bps.
History suggests attractive EM sovereign bonds could post positive returns in 2019
EXHIBIT 8: SPREAD LEVELS AND RETURNS FOR THE FOLLOWING 12 MONTHS
Source: Bloomberg, J.P. Morgan Asset Management; data as of 27 December 2018. Historical returns calculated using monthly data from 31 December 2001 – 30 November 2018.
Past performance is not a reliable indicator of current and future results.
Compared to DM corporates, EM high-yield (HY) sovereigns and corporates are no longer trading at their widest, as was the case last summer (see Exhibit 9). DM corporates were immune to the problems in emerging markets last year, including external financing conditions and idiosyncratic risks (Argentina, Turkey, Russia, etc). However, with late-cycle signals emerging ever more visibly, this gap has started to narrow rapidly (see Exhibit 9).
WHERE IS THE VALUE?
As in any period of volatility, the past few months have created some interesting opportunities in our market. One particular trend has been obvious: the market’s appetite for simple yield gave way to a more nuanced focus on sustainable fundamentals. This has been especially evident in the hard-currency corporate space, where valuations are at historical tights for investment- grade bonds, but BB and especially B rated corporates are trading closer or even wider to five-year averages (Exhibit 9).
In many ways, this makes sense as weaker credits are more susceptible to tighter global financial conditions and slowing EM growth in this stage of the EM cycle. However, such pronounced spread-widening came as a surprise given the strength of corporate fundamentals, especially in credits such as Argentina’s YPF, Pampa Energía or Brazil’s JSL that we flagged for their relative fundamental strength to valuations.
EM valuations have normalised compared to developed markets, but EM HY still offers a decent spread pick-up.
EXHIBIT 9: EM HY-DM SPREAD DIFFERENTIALS
Source: Bloomberg, J.P. Morgan Asset Management; data as of 13 January 2019. EM Sovereign HY = JP Morgan EMBI Global Diversified High Yield Index; EM Corporate HY = JP Morgan CEMBI Broad Diversified High Yield Index; US HY = JP Morgan Domestic High Yield.
Investors questioning the attractiveness of EM HY corporates vs. DM HY corporates should be mindful of the differences in corporate fundamentals between the asset classes. Adjusting the spreads for leverage (see Exhibit 10) clearly indicates that EM corporates trade with an additional EM premium.
Adjusted for underlying fundamentals, EM corporates look attractive.
EXHIBIT 10: SPREAD PER TURN OF LEVERAGE
Source: Bank of America Merrill Lynch, J.P. Morgan Asset Management; data as of 3 January 2019.
Local-currency EM debt definitely has characteristics that make it an attractive opportunity. Despite the lacklustre performance of the past several years, US dollar cycle may be turning as we approach the end of Fed’s tightening cycle. EM FX valuations, although have recovered somewhat in the past quarter, still look undervalued versus historical valuations (see Exhibit 11). With better behaving core rates and tamed inflation, EM local rates should also be well supported. Real yields, particularly in Asia and EM HY ex Turkey, look attractive.
EMFX is still cheap, but some dislocations have corrected and we favour rates markets with higher yields.
EXHIBIT 11: EMFX VALUATIONS (REER* RE-BASED TO LONG-TERM MEDIAN)
Source: Bloomberg, J.P. Morgan Asset Management; data as of 7 December 2018. *REER = real effective exchange rate, rebased to long-term median (January 1995 to October 2018). High yielders = Brazil, Colombia, Peru, South Africa, Russia, India, Indonesia and Turkey.
TECHNICALS: REASONS TO BE CHEERFUL?
In 2018 we witnessed two key elements regarding market technicals. First, they can substantially drive market action despite almost no changes on the fundamentals side. Second, poor liquidity can severely constrain strategy implementation. With these observations in mind and the expectation to see further volatility in 2019, we aim to closely monitor the technical backdrop and liquidity conditions.
There are, however, reasons for optimism when in comes to technicals. The supply and demand picture is looking more favourable this year. We expect net supply to be lower in 2019 than in previous years at around USD 13 billion and USD 22 billion for EM sovereigns and corporates, respectively. Demand is difficult to predict. However, given the small, but persistent outflows last year from EMD, we know that a lot of crossover and other investors now hold significantly reduced allocations to the asset class. With performance eventually rebounding in 2019, we are likely to see some of these investors revisiting EMD.
ROADMAP AND THEMES: PREPARE FOR A SOFT LANDING
In our roadmap for the first quarter of 2019 (see Exhibit 12) we have changed our base case scenario from “Reflation” to “Soft Landing”, acknowledging the re-synchronisation of global growth towards lower levels. We give the Soft Landing scenario a 55% probability. The “Growth Shock” scenario has been assigned a 30% likelihood and “US Inflation” has a 15% probability. We think the Growth Shock scenario is more likely than US inflation because we see cyclical weakness in global growth data and downside risks stemming from trade wars and other idiosyncratic events. The inflation scenario has become less likely as inflationary pressures remain tamed across most developed and emerging markets.
In our base case “Soft Landing” scenario, both developed and emerging countries go through a simultaneous slowdown. For EMD, this is a more favourable scenario than the one we saw through most of the 2018, when the US was outperforming the rest of the world. Financial conditions are likely to continue to tighten, but EM central banks have more room for manoeuvre because of benign EM inflation and pre-emptive interest rate increases in 2018. We don’t expect oil to move much from the current range unless there us a meaningful change in the oil supply.
Our base case is now for a Soft Landing scenario, which should be a more favourable macro environment for EMD than the one that existed through most of 2018.
EXHIBIT 12: MACRO SCENARIOS, INVESTMENT THEMES AND STRATEGY/ASSET ALLOCATION
Source: J.P. Morgan Asset Management, as of December 2018. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication. They constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. IG = Investment grade. HY = high yield. RV = relative value. FC = financial conditions.
In a Soft Landing scenario, we anticipate positive total returns for the year across the three main EMD sub-indices. As global uncertainty and volatility look likely to remain elevated, we prefer countries and companies implementing prudent policies. Based on our Soft Landing scenario, we expect EMD to remain under pressure as financial conditions are likely to continue tightening. In this scenario, we don’t look to have an outright long or short bias to beta, but we aim to start adding on dips as opportunities present themselves. We will be watching China and financial conditions for signals to manage beta risk, while technicals and market liquidity could create some headwinds but also alpha opportunities.
In terms of sectors, we prefer sovereign debt over corporate debt because sovereigns offer more attractive valuations and better liquidity in general. EM corporate debt, which was more resilient through the challenges of 2018, is expected to lag EM sovereign performance because of higher average quality and shorter duration. We want to avoid weak credit in this environment when external conditions are challenging as these weaker names will be the first to come under pressure. Therefore, we aim to have a quality bias across sovereign and corporate portfolios. Within local-currency sovereigns, both local duration and EMFX present attractive opportunities from a valuation perspective and also provides exposure to ongoing structural trends that we want to tactically engage in.