Fundamentals

Emerging market bonds remain supported by a strong underlying fundamental backdrop, anchored by Chinese growth. However, with US Treasury yields moving higher in recent weeks, EMD returns this year will depend on how fast Treasury yields rise, and whether the main driver is inflation breakeven rates (a measure of expected inflation derived from the difference between the nominal yield on a fixed-rate bond and the real yield on an inflation-linked bond) or real yields. Until recently, the rise in nominal Treasury yields has largely been driven by inflation breakevens. In the past couple of days, however, real yields have started to move higher, which is more problematic for risk assets, such as EMD, particularly if the move higher is a sharp one. The rise in real yields has been small so far, and inflation continues to disappoint, with Covid-impacted sectors still weak and housing still subdued. However, with the market focusing on the potential inflationary impact of fiscal stimulus as the economy reopens, the recent increase in real yields needs to be monitored.

Quantitative valuations

Ten-year US Treasury yields are at their highest level since the onset of the pandemic, closing at 1.31% on 16 February. We believe Treasury yields will continue to rise, but at a gradual pace, which should support EMD in an environment where investors continue to hunt for sectors with higher yields and with higher spreads that have room for compression. We continue to like select emerging market local and hard currency high yield sovereigns with strong fundamentals and attractive yields, in addition to a diversified mix of inflation-linked bonds in the local currency space, which could work well in a reflationary environment. We have a more cautious view on investment grade markets in both local and hard currency sovereigns, which tend to be more US Treasury-sensitive. High yield hard currency sovereign spreads, at 594 basis points (bps), are currently 449bps higher than investment grade spreads, which is well below the peak of 801bps reached last March, but still a considerable way off pre-Covid levels. (Data as of 16 February 2021).

EMD spreads continue to compress as US Treasury yields rise

Source: Bloomberg, J.P. Morgan; data as of 16 February 2021.

Technicals

EMD issuance has been high but remains generally well absorbed. Besides, the main argument for technical strength in emerging markets is the demand picture. Our proprietary fund flow monitor, which shows net inflows year to date of $7.6 billion (nearly 2% of assets under management) is evidence that global asset allocators continue to allocate to EMD to pick up yield. Flows could rotate away from EMD if developed market yields rise more than expected, but for the time being EMD remains a bright spot. (Data as of 9 February).