Are there opportunities in EMD?Contributor Alex Dryden
Emerging Market Debt (EMD) had a tough 2018. The J.P. Morgan EMBIG Diversified Index, which measures EMD issued in dollars, fell 6.2% last year. EMD denominated in local currencies didn’t fare much better, falling 4.3%. However, after such a sell-off, there may now be opportunities within the asset class.
Government bond yields around the world remain historically low, meaning that the hunt for yield, which has been going on for much of this cycle, is likely to continue into 2019, benefiting EMD. Currently, the spread of EMD sovereign bonds over U.S. treasuries is at 380 basis points, as highlighted in the chart. At these spread levels, investors can typically expect positive returns in the following 12 months. There have been no negative returns in any 12-month period following spreads rising above 330 bps.
However, some caution is warranted. With the economy now firmly in late-cycle, investors need to focus not just on yield, but also on diversification. Over the last 10 years, the correlation between EMD and the S&P 500 has been at +0.60, meaning any fall in U.S. equities is likely to be compounded by negative returns in EMD too.
Furthermore, there have been signs of excessive exuberance beginning to creep into debt issuance within the EMD universe. For example, in June 2017, the Argentine government issued a 100-year bond at a yield of 7.9%. Argentina has defaulted six times since 1950, but that didn’t stop the bond issuance from being 3.5x oversubscribed.
In short, EMD could offer some attractive opportunities, but investors should proceed with caution. We are now in late-cycle and there has been some excessive exuberance in the space; therefore, we recommend being selective and active in allocating to EMD.