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.
10 March 2023
The changing nature of emerging market debt
Once the wild west of fixed income markets, emerging market debt (EMD) has developed into a mainstream asset class and a staple for portfolios. Away from the noise of day-to-day market movements, we examine the long-term future for the asset class.
Fundamentals
Debate remains around global economic growth with the market split on whether the Federal Reserve is able to engineer a soft landing or if growth will disappoint against current market pricing. While this uncertainty may not present an urgent desire for investments into EMD, there are reasons to be optimistic about the future. Looking past the immediate term, estimates from J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions predict that EMD will return around 7% per annum on a long investment horizon, higher than all other fixed income asset classes. The medium-term investment case for EMD is supported by EM economies being expected to outgrow their developed market peers over the coming year. A reopening of the Chinese economy and a stabilisation of commodity prices supports this expectation for a divergence in economic growth. Moreover, the inflation rate in emerging markets is already declining and should encourage EM central banks to alleviate some of the monetary tightening measures implemented in 2022, further encouraging economic growth.
Quantitative valuations
With a slowdown in global growth seemingly on the horizon, EMD, like nearly all asset classes, typically experiences a drawdown during times of economic hardship. However, the magnitude of EMD drawdowns when global markets are depreciating is shrinking, demonstrating the increasing quality of EMD markets as they continue to develop. For example, in 2008 during the global financial crisis EM Local Currency bonds had a maximum drawdown of 28%, in 2020 during the Covid pandemic this figure was 18% and finally, in 2022 as inflation and the Russian invasion of Ukraine shook markets this drawdown shrunk again to 12%. Separately, real interest rates are higher in emerging markets and with inflation seeming to have peaked, the higher level of carry available vs developed markets should entice investors into emerging markets. In corporate markets, EM companies currently have lower net leverage than their developed market peers for both investment grade and high yield issuers. Yet confoundingly, the spread per turn of leverage is dramatically higher for EM companies, reflecting a significant dislocation in markets.
Technicals
The amount of outstanding tradeable debt in emerging markets has grown considerably over recent years. In 2012, the market was roughly $3.3 trillion in size but has since increased by nearly 150% to $8 trillion today. During this time EMD markets have evolved, with 77% of the market rated investment grade. In EM local currency debt markets, over 94% of the market is rated investment grade. When comparing EMD to other asset classes, we find that the three emerging market sectors of sovereign, local and corporate all offer a high level of yield to maturity with a low level of correlation to US Treasuries. As such, we expect investors will recognise the relative value currently available in emerging markets and increase their allocations as the asset class continues to grow with increased quality of issuance.
Yield and correlation of EMD with US Treasuries
Source: J.P. Morgan Asset Management, Bloomberg, as of 3 March 2023. EM Sov = JPM EMBI Global Diversified. EM Local = JPM GBI-EM Global Diversified USD unhedged. EM Local EUR = JPM GBI-EM Global Diversified EUR unhedged. BB Global Agg = Bloomberg Global Aggregate. US Treasury = JPM US. German Bund = JPM GBI Germany. EUR Credit = JPM MAGGIE. US Credit = JPM JULI ex EM. Correlation: 31 December 2002 – 28 February 2023.
What does this mean for fixed income investors?
EMD allocations within global fixed income portfolios are developing from a niche segment to a core allocation. Strong yields, dislocations in spreads, attractive real interest rates, and diversification provide a compelling argument to allocate to EMD. With this said, the ability to be flexible in EMD markets with rigorous analysis of governments and companies is key. Attractive opportunities are abundant but risks remain if global growth does decline significantly. As such, an active approach is needed to understand and appropriately manage the risk associated with EMD investments.
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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