22 April 2021
Beyond idiosyncrasies
Fundamental risks are ever-present, but the growth backdrop looks supportive for emerging market debt.
Fundamentals
Recent idiosyncratic risks within emerging markets have captured headlines, including sanctions levied on Russia, policy turmoil in Turkey and corporate events in China. Furthermore, the Covid-19 picture arguably looks weaker in emerging markets than in developed: cases are surging in India and Turkey, and the vaccine rollout appears to be lagging the rollout across the US and Europe. Nevertheless, there is cause for optimism around the broad fundamental backdrop for emerging markets. Idiosyncratic stories have largely been shrugged off by the wider EM community, with limited contagion, and while Covid remains a threat, we think the picture should stabilise through the latter part of 2021 as vaccines are more widely distributed. Recent EM growth data has been encouraging: China’s economy grew by a record 18.3% in Q1. With growth accelerating across the region, the outlook for commodities – heavily produced and exported by several key EM countries – is also positive. In this context, we retain our base case of a gradual normalisation across emerging markets.
Quantitative valuations
EM debt has underperformed this year, with EM local currency bonds down 2.3% and hard currency sovereigns down 2.4%. But the move has been driven primarily by the increase in core rates, the speed and scale of which we are unlikely to see again unless inflation in developed markets surprises sharply to the upside. Hard currency sovereign spreads at the index level have been remarkably stable, trading between 335 and 372 basis points (bps) year to date and at an average of 351 bps. At such levels, it is fair to view headline spreads as stretched, and this is something to be wary of. However, there remain pockets of value at the sub-index level. High yield sovereign credit, for example, looks attractive relative to investment grade sovereign credit, with a spread differential of 432 basis points (above the five-year average) and an absolute spread level of 582 bps. We also see value in select local currency bonds: for example, Mexico and South Africa, yielding 6.7% and 9.9%, respectively. Provided any further upward pressure in US rate markets remains orderly, EM debt could offer attractive carry in the coming months. (Data as at 20 April 2021.)
EM underperformance has been linked to Treasury markets, while spreads haven’t moved
Source: Bloomberg, JPMorgan Chase & Co; data as at 20 April 2021.
Technicals
Market sentiment appears robust, with investors largely sanguine around recent idiosyncratic events, and demand is healthy. Anecdotal evidence of investor optimism can be corroborated by flow data: following outflows of almost USD 2 billion in Q1 (exChina-domiciled funds), the trend looks to be reversing, with USD 1.4 billion into EM debt mutual funds in April so far. Positioning in EM currencies also looks cleaner, with client surveys suggesting investors have moved closer to a neutral position in recent weeks. This could go some way to mitigating the risk of emerging markets as a consensus trade. (Data as at 20 April.)
What does this mean for fixed income investors?
EM debt remains one of the fixed income asset classes that stands to gain most from a global rebound as vaccines are distributed and economies return to normal, particularly if buoyant commodity prices act as a tailwind. A key risk is a sharp increase in developed market inflation, which could precipitate another leg higher in rates, in turn potentially disrupting emerging markets. Provided any further rate moves are gradual, we view certain parts of the asset class – such as high yielding sovereigns – as relatively attractive places to invest.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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