25 March 2021
A risk worth taking
While there are risks that investors should be aware of, emerging market debt continues to present attractive opportunities.
It’s perhaps easy to focus on the risks to emerging markets at the moment. The vaccine rollout is lagging the US and UK (with roadblocks in the European Union having a particular impact on central and emerging Europe). Central bank policy is becoming less supportive, with central banks in Brazil and Russia, for example, both lifting interest rates in recent days. And idiosyncratic events still have the potential to dominate headlines, as happened with Turkey this week following the surprise dismissal of its central bank governor. Nevertheless, the fundamental outlook for emerging markets remains robust. Events in Turkey are unlikely to spread to other emerging markets, and the overarching growth outlook is positive as the vaccine rollout continues (albeit at a slower pace). China, a key driver of emerging market growth, looks in particularly good shape, with recent economic activity data (such as property sales, subway passenger volume and hotel occupancy) returning to pre-2020 levels. As this normalisation continues, it should prove supportive for a wider growth recovery across emerging markets.
In line with other fixed income markets, emerging market debt has underperformed in 2021. However, this underperformance has been driven primarily by duration in core rate markets, rather than a significant shift in the positive fundamental outlook for the asset class. Unhedged local currency government bonds have returned -3.26%, with hard currency sovereigns down 3.99% year to date. Emerging market corporates, with less duration, have held up better, returning -0.66%. From a credit standpoint, spreads have remained stable, with sovereign hard currency spreads only 4 basis points (bps) wider, and corporate hard currency spreads 14bps tighter than at the start of this year. Events in Turkey have largely been confined to Turkish markets (the Turkish lira is down more than 9% vs. the US dollar since 19 March), with a negligible impact on sovereign and corporate bond indices. We still favour high yielding US dollar sovereigns, which, with spreads at 615bps, look attractive compared to both US high yield and emerging market investment grade sovereigns. (Data as of 24 March 2021).
High yield emerging market sovereign spreads remain stable and continue to offer value
The propensity for events in Turkey to spread across emerging markets, as has happened in other recent episodes, was restrained by index dynamics. Turkish bonds comprise only around 3.5% of the US dollar sovereign and corporate indices, so most investors have limited exposure to the country. Looking more broadly, technicals look reasonable, with a moderation in flows into emerging market debt balanced by cleaner positioning as investors have less exposure to emerging market currencies following recent underperformance. Technical stress indicators, such as financial conditions and volatility, also remain relatively benign.
What does this mean for fixed income investors?
Overall, the key downside risk for emerging markets remains the path of US interest rates. The fundamental outlook for the sector has not changed, while idiosyncratic events currently appear to present a lower risk to sentiment than previous episodes, as highlighted by the relatively low broad market impact of events in Turkey. In this environment, emerging market credit spreads continue to look attractive, with relative value to be found in high yielding, US dollar-denominated emerging market sovereigns.
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