Are investors at risk of missing the boat on the emerging market debt rally?
After years of languishing for attention, emerging market debt (EMD) is back on investor’s radars. Skepticism about the sustainability of the strong rally in corporate emerging markets debt thus far in 2016 is understandably high, but it has unquestionably served to put the question back on the table: is now the right time to consider getting back into the asset class?
It is still early days, but there are two reasons to suggest that investors reentering EMD stand to reap rewards. The first involves the characteristics of the asset class itself, the second involves the consequences of global central bank negative interest rate policy.
Firstly, the investable universe of emerging markets debt is slowly and steadily expanding, as shown in the chart below. A large component of EMD volume used to be bank financing, much of which has now been refinanced through bonds, adding to the level of debt. That’s created a lot of securities across EMD and with it a broader opportunity and more robust opportunity set for EMD investors.
The market is also currently supported by a few technical factors helping to underpin pricing. There has been very little issuance of emerging market corporate bonds so far this year, resulting in a shortfall of new supply compared to amortizations and coupon payments. That’s good news for investors in the near-term, as scarcity drives up prices. That said, it is more concerning over the long-term because of the increase of maturities for EMD corporate bonds in 2017. The fact that issuers are not pre-refinancing before this looming rise adds uncertainty to the markets; therein lies the paradox of limited supply.
Nevertheless, we are more comfortable with EMD corporates at this stage than we could otherwise have been, as we see fundamentals stabilising from a low level and many indicators for the economy are bottoming out. The environment for businesses across emerging markets has been improving and credit metrics for corporates are growing healthier. Valuations are less challenging as spreads have compressed but are still wide relative to their 5 year average.
The second reason to take another look at the asset class involves it’s characteristics in relative terms.
As the result of negative interest rate policies being pursued by several of the world’s central banks, today more than a quarter of the world’s government bonds are now guaranteeing a fixed loss for investors holding to maturity, and more than half of the developed world’s global government bonds are trading on a yield of less than 1%, as shown in the chart below. Put another way, of the $44 trillion in assets in the global aggregate bond index, 20% of that is trading on negative yields.
The extraordinarily low yields on core government bonds across the developed world continue to make the hunt for income incredibly challenging for investors. By comparison, emerging market debt yields look generous on a relative basis. In our view, investors will increasingly seek out emerging markets debt to help fill this unsustainable yield gap.
As and when investor attention returns to the EMD asset class, it’s worth considering the current drivers for performance and where the most interesting investment opportunities lie.
On the back of a strong rebound in the first quarter of this year in both cyclical EMD foreign exchange as well as more defensive investment grade US dollar denominated credit, we’ve become tactically more constructive on emerging markets debt, meaning that we are re-engaging with risk.
We see signs of stabilisation that bode well for EMD assets in the near-term, particularly in regions such as Latin America and Central Europe, where indicators are bottoming out and retail sales and investment activity is solidifying. We expect economic growth across emerging markets to average a respectable 4% over the next quarter. We’d equate this with a sort of ‘muddle through’ scenario which is friendly for EMD – meaning there is likely little threat from developed market growth overheating and prompting inflation, but also a good chance of avoiding any damaging recession risk.
Although significant challenges continue to plague China, our view there is relatively benign. We believe they will be successful in continued attempts to stabilise their economy: they’ve implemented strong easing policies, shored up their currency and established real estate policies to cool the property market. All of those measures suggest a more favourable medium-term outlook, although we’ll continue to monitor their progress with structural reforms and their accumulation of FX reserves.
We therefore believe that this is a good time to be tactically invested in EMD, although we remain wary of long-term downside risks.
Structurally we’re still cautious over the long-term given the downside risks, but tactically this looks like a good time to be invested across EMD.
The headwinds that complicate our view are the troubling impact that falling oil prices have had on oil exporter countries and the level of fiscal deterioration across EMD assets as EM governments try to stimulate their economies as the cost of widening deficits. Another prospective headline is inflation, where we see significant differentiation between countries. This underscores the importance of a selective investment approach.
In our view, the winners of the EMD trade in 2016 will be higher quality countries – Central Europe, Morocco, Philippines – where investors are well compensated and supported by strong fundamentals. We also currently like the valuation opportunity in selective parts of Latin America and some idiosyncratic high yielders, such as Argentina and Brazil.
Our top investment idea has been to increase duration in sovereign dollar debt, which is near a record high in our EMD portfolio currently, at approximately 6 years. We think duration will be a major beneficiary of the continued search for yield. We’ve also tactically increased our currency exposure to capitalise on the carry opportunities.
As the pendulum of investor attention swings back towards emerging markets debt, the picture looks interesting. As shown in the chart below, returning flows should support pricing and limited supply is creating scarcity. Investors would be well served to proceed with caution, but the sun may be shining again for EMD.
Pierre-Yves Bareau, CIO, Emerging Markets Debt, JP Morgan Asset Management