Emerging market assets should benefit broadly with the Fed on hold
EXHIBIT 1: ASSET CLASS PERFORMANCE SINCE LAST FED HIKE
Source: Bloomberg, J.P. Morgan Asset Management. Average return 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 = GBI-EM Global Diversified. DXY=US Dollar Index.
Past performance is not a reliable indicator of current and future results.
Market overview: the crisis that wasn’t
2018 is notable as much for what didn’t happen as what did, and it is easy to contextualise the performance in the first quarter of 2019 as a response to this outcome. In 2018, investors stepped away from a perception of rising risk and the potential for an increase in both distress and defaults within the EMD space. Tightening liquidity conditions could have led to an increase in issuer distress, just as rising rates, or slowing growth in China or the developing world, could have affected activity and thus service. These expectations largely did not play out, however: 2018’s default rate represented only 1.6%* of total emerging market corporate high yield issuance, a sequential decline vs 2017’s 2.3% default rate. Despite outflows, the market remained orderly in the face of a stiffening technical headwind.
Successful Chinese policy implementation in the face of rising trade tariffs is an important factor in understanding the market’s behaviour in late 2018 and the first quarter of 2019. As an export-oriented economy with a leveraged state banking system, China appeared likely to slow substantially as a result of tariff increases. With fiscal deficit capabilities constrained, Chinese policymakers moved to create a credit impulse by reducing restrictions on state bank lending, while bringing forward other fiscal policy objectives.
The Chinese government increased fiscal spending in December 2018 by nearly 23%* year over year, ultimately increasing expenditure to RMB 22.1 trillion for the year, a 5.1% increase over the previous year. The result is a growth stimulus that may lift Chinese growth from 6.1% to 6.5% at year end, but has risked public sector borrowing credibility and stretched Chinese fiscal balances to do so.
China’s actual fiscal deficit has been above target
EXHIBIT 2: CHINA FISCAL DEFICIT COMPARED TO GDP
Source: Wind, Nomura Global Economics, J.P. Morgan Asset Management. Data as of 31 December 2018. The actual deficit is estimated based on nominal deficit and GDP, using 4Q rolling sum.
Chinese infrastructure investment is set to surge again
EXHIBIT 3: NEW CONTRACT VALUE FOR INFRASTRUCTURE COMPANIES
Source: Company data, Morgan Stanley, J.P. Morgan Asset Management. Data as of 31 December 2018. CRCC = China Railway Construction; CRG = China Railway Group; CCCC = China Communications Construction.
The fact that China continues to add stimulus to its economy continues to be an important driver for EMD. The People’s Bank of China has been an active participant in the domestic swap market, as it seeks to create liquidity in the domestic banking system and fuel growth. Encouraging banks to lend is an efficient way to stimulate economic growth.
The Chinese government has made use of both social financing (which may grow by 10%-13% this year) and fixed asset investment as policy levers, generating increases in demand for commodities, machine tools and other industrial inputs in the process. We note the 26 Chinese provinces have published fixed asset investment plans that total RMB 1.989 billion* so far this year as an indicator of scale. As this stimulus unfolds, the impact on Chinese, Asian and global growth will likely be widespread.
The likelihood is that China and the US will reach a truce in their trade tensions
EXHIBIT 4: CHINESE TRADE AND GROWTH SCENARIO ANALYSIS
Source: J.P. Morgan Asset Management; data as of 31 March 2019.
Emerging market diversity: a source of risk and opportunity
As the Chinese tariff debate grinds towards a near-term resolution, it is worth noting that emerging market diversity remains a source of both risk and return. In South Africa, for example, hard currency investors welcomed progress around ESKOM’s solvency. We see three pillars to the government’s approach to the utility’s finances: direct financial support, a package of tariff increases and a package of cost reductions. Once stabilised, it is possible that the government may seek to reorganise the company into three separate units. These developments had a positive impact across the South African hard currency complex, which was also supported by a more positive external environment.
Elsewhere in emerging markets, the first half promises an active calendar. In Turkey, the results of the election will continue to be felt as policymakers grapple with domestic dollarisation. Tight fiscal and monetary policy will remain key for Turkish policymakers seeking to stimulate domestic growth and thus improve local confidence in policy. The previous year’s volatility had gone a long way towards improving the Turkish current account, meaning policymakers face a decisive period given developments in both domestic banking and the offshore market. A further risk presents around security, as tensions between Ankara and Washington may rise over procurement arrangements. By comparison, Russia continues to show strong macro performance, though the risk of the imposition of sovereign sanctions by the US may offset this appeal.
In Brazil, the market is closely following the progress of the government’s efforts to reform the country’s pension system. If successful, the policy reform could save the state BRL 600 billion* or more over 10 years, which would have a positive impact on Brazilian fiscal policy and therefore competitiveness – which could improve the country’s appeal as an investment destination.
In Argentina upcoming elections will test support for President Macri’s reform agenda. With voters scheduled to go to the polls in late October, there is plenty of opportunity for surprising twists and turns in a race that may polarise investor consensus.
In Mexico, investors will watch for evidence of policy and performance continuity. Slowing GDP growth and fiscal slippage might worry investors. The arrival of ratings agencies in the country for a review will focus investor attention early in the second quarter.
The net effect of these developments is that country specific risk has left many emerging market currencies trading cheaper against the dollar. Underlying fundamental improvement should support some higher beta currencies, which may create an opportunity for investors seeking exposure. Should hard currency valuations continue to tighten, the relative appeal of these opportunities may improve.
Sovereign hard currency: back to the future
For investors in hard currency emerging market sovereign bonds, the question is how much of the year’s returns have already been printed. The first quarter proved an optimal environment for hard currency debt and the asset class duly delivered a return consistent with previous annual returns. Spreads over Treasuries tightened by around 45 basis points* (bps) for the quarter (JPM EMBI Global Diversified), with high yield issues tightening 71bps over the same period. This rally retraces from the fourth quarter wides to bring spreads to levels consistent with the third quarter of 2018, suggesting a possibility that we could go tighter still if the external environment remains supportive.
Emerging market relative value vs developed markets is better in high yield than investment grade
EXHIBIT 5: EMERGING MARKET HIGH YIELD VS US HIGH YIELD VALUATION SPREAD
Source: Bloomberg, J.P. Morgan Asset Management; data as of 31 March 2019. EMBI HY = JPM EMBI Global Diversified High Yield. US HY = JPM Domestic High Yield. 10Y Med = 10-year Median. 1sd = 1 standard deviation
In our view, the high yield arena, particularly in BB rated securities, looks to offer the most attractive opportunity. Should emerging market hard currency bonds continue to appeal to investors, inflows may target the cheaper end of the market. With investment grade hard currency trading relatively tight vs higher yielding bonds, it is possible that we see support for higher yielding issues unfolding as the year plays out.
Corporates: poised for a stronger year in 2019
Having tested investor commitment in 2018, emerging market corporate bonds now appear poised to reward patient investors with a stronger year in 2019. Supported by a better-than- expected earnings backdrop, the emerging market corporate space has benefited from improving balance sheets and evidence of capital discipline, resulting in the best balance sheet metrics we have seen since 2015.
Emerging market corporate earnings continue to improve
EXHIBIT 6: EBITDA* CHANGE YEAR-ON-YEAR CHANGE
Source: Company data, J.P.Morgan Asset Management. Data as of 31 December 2018. *EBITDA=earnings before interest, tax, depreciation and amortisation.
Operationally, corporates show activity consistent with a mid- cycle positioning, though this may change as the year unfolds, reflecting more cautious capital expenditure, and a greater emphasis on debt management and reduction. Debt issuance remains relatively muted, with limited amounts of new paper reaching the street. Because emerging market corporates have been focusing on extending debt maturities, the market has relatively little short-term debt to roll over. With capital expenditure likely to reduce from current levels, a shortage of new issuance in the space may become a more prominent feature.
Corporate net leverage has continued to improve
EXHIBIT 7: EMERGING MARKET CORPORATE NET LEVERAGE
Source: Company data, J.P.Morgan Asset Management. Data as of 31 December 2018.
In our view, corporate spreads could grind tighter for the rest of the year, as investors target the available yield opportunity and embrace the capital discipline of emerging market corporate managements. While the spread of the J.P. Morgan CEMBI Broad Diversified, a widely followed corporate index, continues to trade close to the post-Lehman average, fundamentals remain intact with further support possible in the event of a global economic recovery. With companies maintaining discipline, we note falling default expectations in the space.
Local currency: the case for local currency commitment is strengthening
In our view, local market duration, especially in mid- to higher- yielding names, remains an attractive positioning. With the Fed and European Central Bank both on the sidelines, volatility may dampen, further encouraging emerging market central banks to change tack towards a more dovish approach.
This backdrop presents an appealing confluence of factors for the asset class, and underpins our view that the local currency space may offer appealing returns for the remainder of the year. To best play this feature, we believe there is merit to carrying risk in selected higher beta markets, while avoiding those countries that are more vulnerable or seeing eroding positions. We increasingly see policy credibility as key to understanding how performance may differentiate between countries.
Real carry support for emerging market currencies is relatively strong amid a subdued inflation backdrop
EXHIBIT 8: IMPLIED THREE-MONTH EMERGING MARKET CURRENCY YIELDS AND SHARPE RATIOS
Source: Bloomberg, J.P. Morgan Asset Management; data as of 31 March 2019. Sharpe ratio is on USD-Emerging Markets; EUR-CEE crosses EM FX high yielder basket – BRL: Brazilian real, COP: Colombian peso, MXN: Mexican peso, RUB: Russian ruble, ZAR: South African rand, TRY: Turkish lira, INR: Indian rupee, IDR: Indonesian rupiah.
Historically, a pause in a Fed hiking cycle has been kind to investors in emerging markets generally and local currency specifically. While we do not expect the dollar to weaken substantially, we think it may remain rangebound, thus enabling investors to access the local currency carry opportunity. A further driver of returns for investors lies in the relatively light positioning of foreign investors in the space. Recent volatility shook even a few of the remaining holders out of what is now a relatively under-owned market.
Taken together, we think there is a strengthening case for local currency commitment. The combination of positive carry, a dovish Fed and manageable inflation should enable local currency returns to deliver strong performance to investors.
After a robust first quarter, the outlook for the remainder of the year continues to look positive. In our view, emerging market growth will be 4.4% in 2019, a slight decline from 2018’s 4.6%. However, we expect global growth to slow a touch faster, meaning that emerging market growth alpha should increase to 2.6%, up from 2.3% over the same period a year earlier.
Slowing developing world inflation should keep global inflation relatively muted, thus enabling emerging market central banks to shift their bias towards a more dovish stance, anchored by stable currencies. We think Chinese policymakers will succeed in delivering an improving growth picture in 2019, with Chinese growth averaging 6.3% for the full year, although this view is based on expectations for a trade truce. Political risks remain material in emerging markets and could act as a source of volatility for most of the year, despite a front loading of elections in to the first half of the year.
Emerging market growth alpha should increase this year
EXHIBIT 9: DEVELOPED MARKET VS EMERGING MARKET REAL GDP GROWTH
Source: Bloomberg, J.P. Morgan Asset Management. Fourth-quarter emerging market (EM) and developed market (DM) real GDP growth is according to J.P. Morgan forecasts.
As a result, we expect emerging market returns to be most likely driven by carry rather than by appreciation for the rest of the year. While we expect sovereign credit to enjoy a sweet spot currently, we think the case for local currency debt will improve as the year unfolds. We therefore think there is an argument for a rotation. With core rates likely anchored into the third quarter, a low inflation environment creates a supportive market for both spreads and duration in coming months. We see limited US dollar upside balanced against less clear direction in emerging market currencies. That may open opportunities for greater conviction on specific local currencies, especially if consensus shifts more positively on emerging market growth.
Our base case is for a soft landing scenario to play out this year
EMD ROADMAP FOR THE SECOND QUARTER 2019
Source: J.P. Morgan Asset Management; data as of 9 March 2019. 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. EM = emerging markets, DM = developed markets.