Weekly Bond Bulletin: EM back in vogue - J.P. Morgan Asset Management
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Weekly Bond Bulletin: EM back in vogue

Contributor GFICC Investors

After the spring emerging market (EM) sell-off, the summer has so far seen a reversal in fortunes, with EM debt indices retracing some of their losses since the beginning of June. However, the stronger recent EM performance has seen increased divergence between regions, with trade tensions weighing on Asia in particular. With monetary conditions also tightening globally, can the rally continue?

Fundamentals

The newly released World Economic Outlook update from the International Monetary Fund has reinforced our view that rising international trade tensions  pose meaningful downside risks. On the positive side, EM economies are still poised to grow at a healthy 4.9% in 2018 and 5.1% in 2019 despite tighter financial conditions and negative recent headlines in Argentina, Turkey and Brazil among others. However, more differentiation at a country and regional level is anticipated, with Latin American growth expected to slow by almost half of a percentage point this year, while the Commonwealth of Independent States (the former Soviet Union) and the Middle East should fair marginally better thanks to stronger commodities. Making up over a third of total EM GDP, China remains the key country to watch as it goes through domestic policy tightening to curb excessive leverage and deals with increasing pressure from the US over trade. While second-quarter growth surprised to the upside at 1.8% quarter on quarter (vs. 1.6% expected), we anticipate annual growth slowing slightly over the next few years due to the impact of trade tensions. Onshore liquidity tightening designed to tackle shadow banking and excessive leverage has led to increased defaults and a drop in sentiment among local and international investors. Nevertheless, we don’t expect Chinese policymakers to remain on the sidelines if tighter liquidity starts to affect fundamentally sound companies.

Quantitative valuations

July has started on a positive note for fixed income risk assets. Developed market credit has performed well, with US investment grade returning 0.69%, US high yield up 0.55% and European high yield rising 1.26% since the beginning of the month (to 17 July). After protracted weakness since mid April, EM debt indices have also recovered meaningfully in July, led by EM sovereigns (+1.98%), while local currency sovereigns (+1.36%) and EM corporates (+0.64%) have faired reasonably well too. With trade tensions and tighter policies weighing on Chinese and other Asian country credits, performance between Asian and Latin American credit has meaningfully diverged since June. As relative valuations compared to developed markets remain attractive, we do think the EM rally could have some further legs, but we are monitoring short-term risks from trade tensions that could continue to weigh on Asian bonds, potentially dragging down other regions as well.
 

Latin American and Asian bonds have diverged significantly since the start of June

Latin American and Asian bonds have diverged significantly since the start of June

Source: Bloomberg, J.P. Morgan Asset Management; data as of 17 July 2018. EM local-currency: JPM GBI-EM Global Diversified Total Return Index (in USD); EM sovereigns: JPM EMBI Global Diversified Total Return Index (in USD). EM corporates: JPM CEMBI Broad Diversified Total Return (in USD).

Technicals

As would be expected at this time of year, lighter issuance across fixed income markets has provided positive technical support in the past weeks. In emerging markets, issuance has remained very light, with only two new relatively small sovereign issues from the Dominican Republic and Angola over the past five weeks. Our in-house retail fund flow monitor has also flagged a reversal in the flow picture in recent weeks. From the beginning of July, emerging markets have seen, on aggregate, around USD 1.3 billion inflows, which although relatively small, presents a substantial change from the total outflows of around USD 16 billion that we saw between February and June this year. Positioning surveys, especially on emerging market currencies, point to far cleaner positioning as non-dedicated investors have reduced their exposure to emerging markets over the past months.

What does this mean for fixed income investors?

Recent emerging market outperformance doesn’t come as a surprise given broadly encouraging fundamentals and attractive valuations, especially relative to developed markets. Improved technicals have also been supportive for emerging market debt. However, while the rally has the potential to persist, we don’t expect valuations to reach the levels seen in late January this year, as rising trade tensions, tighter global financial conditions and idiosyncratic EM risks all continue to pose both short-term and longer-term downside risks.


About the Bond Bulletin

It has been a challenging first half, with political and other idiosyncratic risks dominating headlines and provoking the return of volatility, perhaps earlier than we anticipated. However, given the magnitude of some of the moves, we believe valuations are now starting to look attractive, as much of the fallout from negative headlines and geopolitical risk is already priced in to the markets. With a level playing field, the second half should provide plenty of chances to turn the game around.

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