Emerging market (EM) countries have come a long way over the last 20 years in terms of their macroeconomic stability and policy management. Sovereign balance sheets have improved across the board, reducing systemic risks, but there is still plenty of room for additional structural reforms. Moreover, the types of fixed income instruments available to gain exposure have also evolved and matured. We are in an unprecedented period of low interest rates in developed markets [DM], and the significant yield pickup offered by EM assets is potentially attractive for those investors comfortable with the risks inherent in this sector. Moreover, the external scenario with low-but-improving global growth, a manageable U.S. dollar, recovering commodity prices, and the potential for Fed hikes and continued easing by the European Central Bank (ECB) and Bank of Japan (BoJ), has set the stage for continued divergence in performance.
We believe the main question for investors in EM is which EM asset class will outperform, and under what external scenario? Subsequently, within the asset class, the right assets have to be identified that are likely to perform given the external macroeconomic scenario and the fundamentals of the sovereign or corporate in question. Given the current themes driving EM fixed income investments, it is, in our view, important to be flexible and have the ability to reallocate to the asset class that is likely to perform the best. For example, against a backdrop of broad U.S. dollar strength, EM currencies are likely to weaken and a prudent choice for investors may be to express fundamentally constructive views toward EM through U.S. dollar-denominated bonds, either sovereign, corporate or both. Meanwhile, a combination of disinflation and steep domestic yield curves might argue for duration exposure in certain countries where inflation expectations are well-anchored.
After a short-lived sell-off following the U.S. election in November 2016, EM fixed income rebounded convincingly, posting robust returns in 2017, and outperforming other asset classes by a wide margin. EM local currency (as measured by the J.P. Morgan GBIEM Global Diversified Index) has returned 13% year-to-date (of which 8% corresponds to carry/duration returns, and the remaining 5% due to foreign currency (FX) appreciation vs. the USD).1 Meanwhile, hard currency EM sovereign debt (as proxied by the J.P. Morgan EMBIG Index) has posted a positive return of nearly 9%, followed by EM corporates which have delivered 7.3% returns year-to-date (as measured by the J.P. Morgan CEMBI Broad Diversified).1
Obvious concerns to investors include whether the EM debt asset class will be able to sustain such solid performance in the near future, and which subasset class within EM Fixed Income is likely to outperform. For example, if growth accelerates and output gaps close, how will inflation and EM central banks respond? These concerns seem more urgent now as we witness the end of unprecedented global monetary accommodation, and as markets appear to be revisiting the “Trump reflation” trade that hurt investor sentiment towards EM during the last months of 2016.
Our view remains constructive overall on the asset class in the medium term, on the back of supportive EM idiosyncratic fundamentals, still attractive yields compared to alternatives in developed markets and some room for valuations to tighten further. Notwithstanding our benign medium-term view, for the remainder of the year, we advocate a cautious approach to the asset class in view of the sizable outperformance year-todate, an incipient revival of the “Trump reflation” trade on higher odds of a U.S. tax reform being approved by Congress and a host of tail risks including, among others, geopolitics (most notably, the escalating conflict between the U.S. and North Korea) and the U.S. government’s potential anti-trade initiatives (particularly, a bad outcome on the North American Free Trade Agreement (NAFTA) renegotiation and/or measures impacting U.S.-China trade relations).
We therefore prefer a more selective allocation to EM currencies in the near term, preferring idiosyncratic stories with high carry, such as Egypt, Argentina and Uruguay, and undervalued currencies such as Malaysia. We like local rates on the back of attractive valuations, though we acknowledge that duration may be challenged in the short term by higher/rising U.S. Treasury yields and lower disinflationary impulse. In particular, we prefer overweight duration exposure to reform-minded countries with attractive yields such as India and Indonesia, or with ongoing disinflation and tight monetary policies (Russia and Brazil). On the other hand, we choose to avoid low-yielders such as Thailand and Czech Republic, or countries with deteriorating fundamentals, such as Colombia. Regarding sovereign spreads, we think valuations have some further room to tighten, and we are biased in favor of countries with ongoing reform agendas and/or high yields such as Indonesia, Argentina and Ukraine, and avoiding low- yielders (such as Chile), or deteriorating macro/political stories (Colombia, South Africa and Turkey).
Within EM corporates we remain overweight higher-yielding, lower-rated credits as the default cycle has bottomed and we should begin to see the ratio of ratings upgrades to downgrades rise in the near future. Within this high-yield segment we are favoring idiosyncratic stories in countries with stable-toimproving fundamentals, while within investment grade credits we have focused on lower-rated companies within the 7- to 10-year segment of the yield curve, as well as perpetuals with punitive stepup provisions. Within Asia, we favor China via higher-quality state-owned enterprises (SOEs) and new economy companies, as well as India (oil & gas and clean energy plays) and Indonesia (property and technology, media and telecommunications). Within Latin America, we favor Argentina (reform story offers attractive risk/reward as the country re-enters the global capital markets) and Brazil (oil & gas SOE, financials and local champions in core sectors such as proteins).
1. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure page for index definitions.