Re-emerging market debt
The improving economic outlook for emerging markets along with supportive currency dynamics and index reweighting combine to make a powerful tailwind for the performance of emerging market (EM) debt.
Hard currency and local currency EM debt put in strong returns in the final quarter of 2020 at 5.5% and 8.5%, respectively, as yields fell.1 However, while falling yields and rising valuations may dissuade some investors from EM debt, the corporate debt markets in the developed world have experienced a similar if not more dramatic shift in valuations and falling yields. For example, the yield on U.S. high yield debt fell to its lowest level in 10 years in February 2021.2
Economic growth in emerging markets should outpace the developed world, widening the growth differential. Regionally, Asia is leading when it comes to economic strength, given the more successful suppression strategies on the pandemic and China’s role in lifting activity in the region as a whole. The broader global recovery has also created a favorable environment as the global goods cycle has resumed. While China and Asia may be the focus for now, we expect emerging Europe and Latin America to catch up as long as a successful vaccine distribution strategy follows and allows for a return to more normal economic activity.
Stronger levels of economic activity and rising rates of inflation have increased speculation around rate hikes by emerging market central banks. Russia and Turkey have become more hawkish as the growth and inflation outlook brightens; meanwhile, the central banks of Korea and China have raised concerns over asset price inflation. A broad tightening of monetary policy across the EM universe is unlikely given the early stages of economic recovery. Meanwhile, macroprudential policies may be deployed to control the less desirable side effects of lower rates.
The potential for further EM currency appreciation should add to local currency EM debt returns for offshore investors. At the start of the COVID-19 outbreak, EM currencies were quick to sell-off. From the end of 2019 to its low in 2020, the JP Morgan EM Currency Index fell by 15%. While EM equity and bond markets may have recovered to their pre-pandemic levels, currencies have not. The index remains 5% below where it was at the end of 2019. The strengthening economic outlook and positive risk sentiment should mean a continued recovery in EM currencies.
Spreads have narrowed sharply in corporate credit, but EM debt still looks relatively attractive as a source of income
EXHIBIT 1: FIXED INCOME VALUATIONS
Source: iBoxx, ICE BofA, J.P. Morgan Economics Research, J.P. Morgan Asset Management. Based on J.P. Morgan Domestic High Yield Index (U.S. high yield), J.P. Morgan U.S. Liquid Index (JULI) (U.S. investment grade), J.P. Morgan Euro High Yield Index (Euro high yield), iBoxx EUR corporates (Euro investment grade), J.P. Morgan Asia Credit Index (JACI) (USD Asia credit), J.P. Morgan Asia Credit China Index (USD China offshore credit), J.P. Morgan Asia Credit High Yield Index (USD Asia high yield), J.P. Morgan EMBI Global (EMD USD), J.P. Morgan Corporate Emerging Markets Bond Index – CEMBI (USD EMD corporates), J.P. Morgan GBI-EM Global (Local EMD). Positive yield does not imply positive return. Past performance is not a reliable indicator of current and future results.
Guide to the Markets – Australia. Data as of 17 February 2021.
Investment Implication
The positive economic outlook and divergence in economic growth to developed markets sets up a positive case for EM debt. An additional boost comes from the ongoing liberalization of the Chinese bond market, and its integration into global fixed income bond benchmarks will impact flows.
The process of integrating Chinese bonds into global benchmarks began in 2019 with inclusion in the Bloomberg Barclays Global Aggregate Bond and the JP Morgan GBI – EM indices. The FTSE World Government Bond Index will start to include Chinese bonds from October 2021 and bring new inflows as investors re-weight holdings to match benchmarks.
However, investors should be aware of some potential risks—at the top of which is the expected success of any vaccination strategies being employed by each country and the additional uncertainty around where some emerging economies sit in the global queue to access vaccines.
A continued rise in U.S. Treasury yields on the basis of a stronger U.S. economy may lead to a rising rather than falling U.S. dollar. This would weigh on the revival of EM currencies and the attractiveness of EM assets.
Sovereign default risk and the potential for liquidity stress for holders of EM debt are lower in an economic upswing. However, countries with elevated debt levels may still be more vulnerable to sustained dollar strength.
Overall, the yield compression in governments is extending into corporate credit and spreads have narrowed sharply. EM debt still offers higher yields at relatively attractive valuations and with perhaps the most favorable economic and technical backdrop for some time.
1Hard currency EM debt is the JP Morgan EMBI Global Index, and local currency is the JP Morgan GBI-EM Index, total returns in U.S. dollars.
2Based on the Bloomberg Barclays U.S. Aggregate Credit – Corporate – High Yield Index.
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