Emerging Market Debt Strategy Q1 2020
- We expect another positive year for emerging market debt in 2020, with base case expectations of about 8% returns for emerging market hard currency, and 11% for emerging market local currency. With currencies presenting a near pure beta play, we believe that hard currency debt may have a marginal performance edge on a risk-adjusted basis.
- Our investment views incorporate a low-growth base case scenario for the developed world and an acceleration in emerging market growth from 4.1% in 2019 to 4.3% in 2020. Although Chinese growth is set to continue to decelerate, recoveries elsewhere should boost emerging market economic activity. We therefore expect the emerging market growth premium over the developed world to widen to 2.9% in 2020, the highest level since 2016.
- Compared to last quarter we now expect closer relative returns, supporting the case for a more balanced asset allocation going forward.
- We think local currency debt is attractively valued and expect increasing investor flows following recent strong performance. We see room to add more anchored emerging market currencies within our more flexible strategies. Within the hard currency world, we continue to find value in high yield, especially within the BB complex.
- Weaker corporate earnings and a higher default rate mean we are entering 2020 with a more negative outlook for emerging market corporate debt but balance sheets remain strong, particularly in investment grade.
Improving growth outlook to support emerging market debt in 2020
We expect another positive year for emerging market debt in 2020, with base case expectations of roughly 8% returns for emerging market hard currency, and 11% for emerging market local currency. With currencies presenting a near pure beta play, we believe that hard currency emerging market debt could offer a marginal performance edge on a riskadjusted basis.
Central to unlocking these expected returns is the continued validity of our low growth base case scenario for the developed world. We believe emerging market growth can accelerate from 4.1% in 2019 to 4.3% in 2020. While we expect a continued growth deceleration in China, recoveries elsewhere—for example Brazil, Indonesia, Turkey and Russia—should contribute to improving growth.
Forecasts are not a reliable indicator of future performance.
All data is sourced by J.P. Morgan Asset Management as of December 2019 unless otherwise stated.
We expect the emerging market growth premium over the developed world to widen to 2.9% in 2020, the highest level since 2016 (Exhibit 1). We believe the US economy will avoid a recession in 2020, and that the European economy should see an improvement in export demand. While leading indicators point to a stabilisation in European growth, we have not yet seen an increase in activity. Much of our growth expectations in 2020 rely on a Chinese recovery, which appears to be increasing in probability. Recovery feeds from better sentiment, so a resolution to ongoing trade tensions will be crucial if emerging market and global growth is to gain momentum.
We expect the difference between emerging market and developed market GDP to widen slightly
Exhibit 1: Real GDP growth, % quarter on quarter (seasonally adjusted annual rate)
Emerging market economic growth is dependent on demand for the bloc’s exports. Over time, the composition and value-add of this component has matured. Today’s increasingly sophisticated EM exports now account for a greater portion of global manufacturing and an increasing amount of intra-emerging market trade. Emerging markets now enjoy a greater level of growth resilience in the event of a slowdown in the developed markets, or China.
Interest rate cuts from emerging market central banks have helped to sustain this resilience. Easier monetary policy helped to protect growth in 2019 but many central banks now have less policy room in 2020. This leaves the emerging market world vulnerable to a growth shock if trade wars intensify, with tradesensitive currencies an acute source of risk. However, less monetary policy flexibility means we expect to see increasing use of fiscal policy. Emerging market fiscal stimulus has been led by Asian and EMEA (Europe, Middle East and Africa) countries. Inflation also remains well anchored, though dispersion is beginning to appear, which is important as it means selectivity will remain an important component of portfolio construction.
Against this backdrop we expect emerging market debt to take some leadership from external drivers. A divided US government is unlikely to deliver large shifts in policy and it is possible that the associated uncertainty is negative for growth. With weak growth, low inflation and a plethora of sources of uncertainty in play, we continue to expect developed market core rates to remain low. These negative factors in the developed world may become a technical positive for emerging market debt: with G4 balance sheets expanding at an annual rate of USD 1.2 trillion, emerging market debt is likely to present a strategic source of real yield for investors.
While we expect core financial conditions in the world’s developed economies to remain easy, late cycle credit and earnings dynamics provide a risk to this thesis. Accordingly, we think the US dollar may shift to a weakening bias, with additional drivers of monetary stance shifting to a more expansionary footing. Taken together, these factors underpin our belief that emerging market local currency debt could potentially perform well in 2020.
China: Next steps in the trade war
Our base case expectation for the Chinese economy in 2020 is 5.6% GDP growth, marked by an incremental recovery in the second half of the year. In our view, a “phase one” trade deal with the US that removes or amends existing tariffs is possible, though difficult negotiations lie ahead. These could include intellectual property enforcement and technology transfers, among other areas, that may prove controversial to both sides.
We think a number of key points behind the current trade tensions may remain unresolved, including the Huawei 5G issue, a number of “Made in China 2025” policy directives, the South China Sea and the “One Belt One Road” programme. Taken together, these points form a material risk to our thesis, given their capability for surprise. A further intensification of the trade war is possible, potentially reflected in new tariffs and restrictions on Chinese individuals and activity. China is not defenceless, and maintains the capability to push back—up to and including weakening its currency. So far, the Chinese response has focused on stimulating domestic activity, through infrastructure investment, tax cuts for small businesses, and other incentives.
We have factored continued trade tensions into our expectations for Chinese growth. We assign a 35% probability to the completion of a phase one trade deal, which we view as positive for Chinese growth. Successful completion of a phase one deal raises our expectations for Chinese GDP growth to 5.6%. In our worst case scenario, to which we assign a 10% probability, trade tensions intensify to include a 25% tariff on a further USD 265 billion in Chinese imports, plus the addition of “poison pill” measures in the fourth quarter.
Within our base case assumptions, we assign a 30% probability to a “Cold War” scenario where the trade war broadens to include Europe and Japan and the 25% trade tariff extends to include all Chinese imports. In this scenario we expect Chinese growth to drop to 4.2%. We think there is a 25% chance of an easing or postponement of the trade war, in which we believe that China could grow 5.4%. On a probability-weighted basis, it is possible 2020 Chinese growth slips to 4.9%, though we acknowledge a dispersion of risk around this expectation (Exhibit 2).
Three scenarios for the trade war and their impacts on Chinese economic growth
Exhibit 2: Impact of the trade war on Chinese economic growth
A cooling Chinese economy will have global implications, reflecting in weaker manufacturing data in both developed and emerging markets. China is a major driver of the 40% of the global industrial demand that originates in Asia, meaning that the trade war impacts European car manufacturers, metals producers and commodity-related industries accordingly. While American manufacturing accounts for only 5% of exports, in Europe the sensitivity is more elevated, as manufacturing accounts for 16% of total exports.
However, Chinese investment in technology is likely to power a recovery in the semiconductor cycle in the first quarter, eventually supporting a mid-year turn in the Asian manufacturing cycle, and finally a pickup in the industrial cycle towards the close of the year. A recovery in the Asian manufacturing cycle does not mean that China’s repaired the damage from the trade war, but rather that the economy is on a pathway to do so.
Currently, Chinese factory activity is visibly slower than that seen in September 2017 (Exhibit 3), with intermediate goods (for assembly) continuing to slow. Wage growth has slowed accordingly and household disposable income has fallen. A gradually improving global purchasing managers’ index suggests that support may be forthcoming, barring another flare up in the trade dispute.
China has responded to consumer weakness with tax cuts while Chinese banks have been increasing credit. We expect China to continue injecting stimulus into the economy, possibly increasing by 8%-11% in 2020 and coinciding with a RMB 1 trillion increase in local government debt raising. These actions should create growth resilience going forward.
Beyond the urgency in these policy decisions, China faces longer-term growth worries. The realities of China’s ageing population, for example, will become more visible through rising dependency ratios in the new decade. China is looking to offset the impact through the creation of an industrial and technological hub in the south east of the country. We expect China to spend around USD 200 billion per year over the next 11 years to bring next generation infrastructure to a small core of cities in this region.
The composition of China’s trade accounts has also changed. Nearly 35% of China’s exports now go to the emerging world, versus less than 15% that go to the US. This shift in composition has helped the Chinese trade account and improved investor sentiment toward China. In the fourth quarter of 2019, China received nearly USD 25 billion in bond inflows, reflecting investor confidence in its policy and the appeal of a substantial rate differential. While the Chinese economy is slowing down, we think Chinese government bonds will remain relatively stable. We expect the People’s Bank of China to maintain liquidity and gradually allow rates to fall, though we think they will continue with the policy of a rate buffer.
The bounce in global industrial production is from the technology cycle; manufacturing, industrial and auto output remain weak
Exhibit 3: Global industrial production (IP) by sector, % change month on month
Emerging market alpha: Key country views
While we expect a solid return from emerging market debt in 2020, we think the dispersion within the asset class—and the momentum around that dispersion—will drive performance. Our 2020 scenarios suggest a wide range of opportunities in emerging market currencies and local currency debt, while credit default swaps remain broadly expensive.
Russia and Mexico may outperform Brazil and Chile
In Russia, although the risk of sanctions remains, we think Russian bonds will likely stay out of scope. Russia currently operates a twin surplus economy, which helps the outlook for hard and local bonds alike. In our view, the currency could appreciate by around 4%, especially if the central bank cuts rates less than expected, which would create considerable value in local bonds and could attract strong support for the market. The imposition of sanctions against Russia could materially weaken both the local currency and local bond prices.
Although Mexican fiscal performance was one of the positive surprises of 2019, we think a US slowdown will present a rising headwind. We expect to see a gradual deterioration in Mexican fundamentals, as consumer strength is already fading and business sentiment weakening. As a result, Mexico’s ratings are at risk of being downgraded by Moody’s and S&P, both of which already have a negative outlook. We also think the state oil monopoly PEMEX is likely to have its rating downgraded in the first half of the year.
Despite these expectations, Mexico’s risk premium appears to be cheap. We assign a 15% probability to a more bearish outcome, with the biggest risk being a shock to the real economy from tariffs, downgrades, a deep recession or a large fiscal or political shock. In light of these risks, we think it likely that Banxico continues to ease rates to around the 6% level. Given the higher probability of the gradual deterioration scenario, we believe Mexican local bonds continue to offer value.
The outlook for Chile looks more complex. We believe the most likely scenario is that the country muddles through the current political situation, but the risk of major changes is not negligible. We see room for the currency to strengthen if Chile resolves its issues, and more material weakening if it fails to do so. These risks are reflected in local bond yields. In our view, increased fiscal spending may smooth the path towards a new constitution and government. The planned plebiscites in April and October 2020 also create risk for investors, as the outcomes could alter the fundamental framework of the country. We will watch both events closely.
With social security reform now passed, Brazil’s political leadership will address a myriad of less visible reforms. If successful, we expect to see Brazil posting better fiscal and growth projections. The challenge is that the market may look prematurely for evidence of growth and thus a re-rating. Were progress on reforms to regress, investors could easily withdraw some of their recent enthusiasm, which could result in both a weakening of the currency and a material increase in local yields. However, we think it more likely that reforms will continue to gather momentum, and that this will reflect in a moderately stronger currency.
South Africa and Indonesia: Potential challenges ahead
South Africa enters the new year facing a number of challenges, perhaps most notably around the budget, which is expected in February. Rating agencies will look for evidence of improving fiscal discipline. Should South Africa fall short, the country’s bonds will likely fall below investment grade, resulting in their exclusion from the widely followed World Government Bond Index (WGBI). We think it likely that the central bank remains constrained by the fiscal policy outlook.
Indonesia enters the year in a relatively better position. In our view, it is likely that the country maintains the current status quo economically, helped by President Jokowi’s policy continuity. This makes local rates in Indonesia attractive. The main risk for Indonesia is that the country is sensitive to broader market beta, meaning an escalation of the trade war or another negative global event could potentially shock the local economy.
Turkey: Looking for a cyclical upswing in 2020
We expect Turkey to muddle through its challenges in 2020, which should strengthen both the currency and local bond prices. We see an upswing in the Turkish cyclical indicator, which in turn points to a recovery in economic growth, likely due to the combination of fiscal, credit and monetary impulses, which we expect to align in 2020.
Turkey’s current account is also on an improving trajectory and we expect it to move into surplus in the coming year. Inflation is also moderating. Turkey’s deteriorating public finances present a risk, albeit one that is reduced through growth and easing external debt issuance pressure. Hence we see some value in hard currency Turkish bonds.
Emerging market hard currency: Searching for quality income
Emerging market hard currency debt valuations have increased as more investors seek quality income. For managers, a paramount concern is avoiding the drawdown that follows when countries deliver negative surprises, as hard currency debt has entered a period where the market has become more judgemental and punishes those countries that deviate from trend.
The quality income theme has tightened the investment grade market and is prompting investors to reach across into high yield in search of upgrade candidates and mispriced value, which makes calling a broader beta trend more challenging. We continue to see value in the BB arena, where more attractive spreads may benefit from the relative tightness seen in the BBB universe (Exhibit 4). In this market, we think credit differentiation continues to be crucial for successful investing, though we caution that the Treasury call may yet again be more important than the spread call.
BB spreads look attractive versus the tight BBB universe
Exhibit 4: Change in bb to BBB/B three-month spread
Increasing social tension generated substantial risk in 2019, and we think will continue to do so in the near future. Looking at socio-economic indicators, we see youth unemployment rising ominously in a number of countries, while corruption and concentration of wealth are becoming more paramount in others. An evaluation of these factors suggests a concentration of risk in both Middle East and Latin American countries, an observation that we remain mindful of in our investment strategy. We further note that the increasing prevalence of investments based on environmental, social and governance (ESG) factors has had a performance impact, enhancing issuers with more positive scores. We expect the pool of ESG-aware assets to continue to grow.
Emerging market local currency: Improving sponsorship, brighter outlook
Local currencies look attractively valued (Exhibit5 ), supported by G3 central bank balance sheets that are continuing to add reserves to the system and growth expectations that are rebounding from a low base. Within local curves, we think duration remains anchored by core rates, though individual country allocations are in places more finely balanced.
Local currency yields look attractive
Exhibit 5: Real yield by country versus five-year average standard deviation
As the market embraces expectations of a stable or softening dollar, investors have increasingly turned to the local currency space as a source of both performance and higher yielding duration. We think the optimal positioning for investors is currently to build exposure to selective duration while playing tactical currency beta. However, as momentum towards local currencies builds, we think a shift towards higher beta names— for example, higher yielding local issuers—might produce higher returns.
Supporting this transition is an improving level of investor engagement. While emerging market local currency bonds have lagged competitive asset classes in recent months, recent data shows a sharp pickup in flows into local currency versus peer assets. We expect seasonality and 2019’s stronger performance to trigger further flows into the asset class and support performance early in the first quarter.
Emerging market corporates: Late cyclicality, strong credit quality
Of the three emerging markets asset classes, emerging market corporates show the most evidence of late cyclicality. However, after several years of prudent balance sheet management, they also appear well prepared for an eventual slowdown. The market has rewarded these corporate performances with relatively full valuations, meaning investors expect a solid performance into a moderating headwind.
At the aggregate level, a negative earnings trend may add pressure to the sector, though overall sector leverage remains well below the 2016 peak (Exhibit 6). Emerging market corporates have also been reducing capex levels over the last few years, particularly in Latin America. Interestingly, emerging market corporate debt issuer forecasts indicate that the current weakness in earnings is likely to continue, while emerging market equity forecasts are pricing in a rebound. It is worth noting that the two markets differ markedly in issuer composition.
In addition to corporate earnings, we see a number of factors in the year ahead that may influence returns. Between 2020 and 2022, there will be a substantial increase in external bond maturities, dominated by Asia and EMEA, with China being a major contributor. Within China, the bulk of these maturities come from investment grade issuers. Within the Chinese high yield space, we expect real estate borrowers to be able to access finance, as many issuers have been actively prefunding 2020 maturities. We expect the peak for high yield debt maturities in April, with some USD 7.3 billion coming due (July’s USD 7.5 billion is a higher overall total, but the composition is oriented more towards investment grade).
With concern on late cyclicality in sharper focus, it is not unreasonable to expect the market to look more closely at default risk as a potential source of performance impairment. In recent years, emerging market corporates have proven themselves good servicers, presenting a relatively low default rate. 2019 continued this trend, with a 1.2% overall default rate. We think default rates will increase modestly in 2020 to roughly 2.4%, including distressed Argentina (Exhibit 7). Removing Argentina reduces our expectation to 1.7%, a level more consistent with recent performance.
Weaker corporate earnings and a higher default rate mean we are entering 2020 with a more negative outlook for the broad market. As such, we believe that 2020 will be a year where excellence in credit selection can create value for investors. We also note that differentiation within emerging market corporate debt is wide: investment grade balance sheets look solid, but the high yield space looks more vulnerable.
With the credit cycle maturing, we think the majority of emerging market corporate sectors will report past-peak credit fundamentals, with financials following suit over the next 12 months—a situation that would present more of a challenge if balance sheets in the broader emerging market corporate universe were not beginning the process from a strong position. As a result, we do not see defaults disrupting the story as has happened in the past, which gives us scope for selection. While we are more bearish than consensus on earnings, we still see solid credit fundamentals within the space as a whole.
Also, while the refinancing schedule is brisk in 2020, we think many corporates have moved ahead of the curve and are thus well prepared to manage maturities over the next year. The major concern in the corporate space is that the improving macro environment is not yet strong enough to generate much performance, while faltering growth could expose investors to greater downside risk.
Leverage in the emerging markets corporate sector remains well below the 2016 peak
Exhibit 6: Net leverage across EM high yield
EM corporate default rates remain low but will likely increase slightly in 2020
Exhibit 7: EM corporate high yield default rate
Conclusion: Headed towards the mainstream?
Our base assumptions look for a continuation of the current low growth environment, with key drivers around trade and politics ranged against developed market easing. For this reason, we believe that core yields will remain contained, meaning emerging market currencies are likely to appreciate due to G4 balance sheet expansion and softening US growth.
We think the emerging market growth premium will recover, which is an essential component of our investment thesis. While we think Chinese growth may slow further to 5.8% in 2020 as a result of the trade dispute, we see other emerging market economies recovering while the developed world slows. Emerging market accounts show no large imbalances on aggregate, but differentiation remains key, especially as some central banks have actively used policy ammunition. Therefore, not all emerging markets still have room to ease, with fiscal space even more limited. The increasing prevalence of social tension, both globally and within emerging markets, may pressure already vulnerable emerging markets, and remains a key risk for us in 2020.
Our base scenario expects another solid year for emerging market debt investors in 2020, though our riskier scenarios are more pessimistic. This argues in favour of a more balanced asset allocation, and hence we think there is merit in rotating from external credit and local duration into emerging market currencies early in the year. Valuation provides some comfort in external credit, though more for sovereign and BB rated bonds. Locally, we like duration in mid- to high- yielding countries where we see scope for policy easing, such as in Mexico, Peru and Russia.
With core yields in European sovereign bonds remaining low, we think emerging market real growth and real yields will continue to look attractive, leading to a structural “mainstreaming” that should support the asset class in the year ahead. With lower net supply expected in 2020, we may see these flows result in further performance resilience.